Rules and procedures for issuing government guarantees Introduction

to the government as guarantor. To counteract such behaviour, the guaranteed borrowers must be subjected to monitoring, an activity which in itself is costly.

For credit guarantees to be economically justified, they must bring advantages that outweigh these drawbacks. We point to two sets of potential benefits.

First, it may be possible to use guarantees in a way that allows the government to share the credit risks with the lenders. Risk sharing gives the lenders incentives to monitor the borrower, reducing the government’s responsibility. It also limits the lenders’ ability to take undue advantage of the guarantee. Risk sharing is possible also using direct lending, however, so this factor does not in itself help discriminate between the two alternatives.

Second, there may be administrative benefits from involving outside lenders in a government-sponsored program. The lenders can take care of the granting and distribution of credit, under the protection of a government guarantee. Such advantages are more likely in programs involving a large number of borrowers than in cases where guarantees are issued to a specific borrower with sizable funding needs. Risk sharing is essential also in such programs to prevent lenders from being careless in their handling of credit risks.

Whether these potential advantages are sufficient to outweigh the higher financing cost will vary from case to case. Each proposed guarantee (or program) has to be evaluated on its own merits, including a careful evaluation of alternative solutions.

Our subsequent analyses focus on how to devise a sound governance system for government guarantees. Such a system should ensure appropriate use of guarantees and limit the opportunities and incentives to use guarantees in cases where better instruments – as seen from the taxpayers’

perspective – are available.

III. Rules and procedures for issuing government guarantees

therefore be such that they foster transparency and avoid situations where guarantees are used despite there being more efficient instruments for achieving policy objectives.

Budget treatment of government guarantees

The starting point is that a guarantee is a commitment of government resources. Consistency therefore requires that guarantees are issued under the same rules and procedures that govern other uses of government resources. This means, in particular, that guarantee issuance should be integrated into the budget process.

The potentially hidden nature of guarantees may cause serious fiscal problems for governments. If the inherent risks of guarantees have not been recognized according to their economic value, they may require use of public resources well above the amount the government has expected to provide.

Unless checked by appropriate procedures, guarantees can cause big holes in public finances. In order to support unbiased decision-making, decisions relating to guarantees should follow the same pattern as decisions relating to direct use of resources (state aid, loans and subsidies). Issuing procedures should ensure that guarantees are handled in a transparent way. Part of this objective of transparency can be achieved by an unbiased and systematic valuation of guarantees, and by accurate reporting of the measured values.

Another part is the enforcement of fees reflecting the costs of guarantees in the budget process. The expected amount of public resources that the guarantee uses should be disclosed and set aside ex ante. One way of meeting these demands is to stipulate that a government guarantee can only be issued if an ex ante fee is paid. For a subsidised guarantee the fee should be taken out of the current budget to ensure that the guarantee is acknowledged in the budget process. This puts a price tag on the decision and allows comparisons to other uses of government funds and to other ways of financing the guaranteed activity. Moreover, fees covered by budget means increase the likelihood that other expenditures are reduced, thus improving the government’s ability to meet any realized payments under the guarantee. For a guarantee issued to a company active in a competitive market, the recipient should pay the fee. This compensates the government for the resources committed by issuing the guarantee and avoids hidden state aid.

The guarantee fees paid by the recipient of the guarantee or from the budget can be put into a reserve fund. By establishing a reserve fund, the government can make the inherent risks and values of guarantees more transparent. A fund can include also a margin amount, over and above the expected costs, to act as a buffer in a worse than average scenario. In a country with a weak fiscal position, this may be a necessary precaution to take.

In some cases, the reserve fund can be a notional fund, in the sense that it is a reporting item rather than an actual fund invested in specific financial assets. With a notional fund, the fees reduce the outstanding conventional debt, assuming that subsidised guarantees actually crowd out other expenditures and that fees paid from outside the government are not used for other purposes. A smaller initial debt implies that there is more room for the government to borrow if and when a guarantee has to be honoured.

An actual reserve fund held within the government raises the reported gross debt compared to a notional fund. It also raises questions concerning in what assets to invest the fund and how to mange those assets. For example, a fund made up entirely of government bonds is easy to manage, but is also not much different from a notional fund. If other assets are included, credit risks must be managed so as to assure that the fund is available when guarantee payments have to be made. But if an actual fund is considered helpful in restricting the use of the resources actually committed to guarantees, it may be an effective means to reduce the fiscal risk that the government faces.

The choice between actual and notional funds will vary from country to country, depending on, for example, the rules governing the state’s budget and debt, in particular, whether payments of budget means into a notional fund can be expected to lead to actual cutbacks in other expenditures. The strength of the government’s overall balance sheet is also relevant.

A fund combined with reporting of the current value of the outstanding guarantees makes the latent costs of contingent liabilities transparent. If payments under guarantees are charged against the fund, one also gets an indication of whether fees are set in line with actual costs, at least on average, which permits ex post evaluation of the system. A shortfall between the fund and the current liabilities is a signal that the guarantee system is not in balance and that policy measures may be required.

Procedures for issuing government guarantees

Guarantees should generally be used only if other means of support or finance are considered more expensive and/or more risky than guarantees. As part of the process of justifying guarantees, the procedures should thus require an analysis showing that a guarantee is more efficient than direct support in the form of subsidies or loans. Ensuring that identical fees are charged for solutions that have the same implications for cost and risks is one important element in such a framework.

Moreover, all existing guarantee programs should be reviewed regularly and analysed against program goals. For example, the government should from time to time consider transferring the program to a separate guarantee company with limited liability. Even though existing government guarantees

cannot be transferred, this kind of exercise can be used as an acid test for evaluating the need for government participation and as a basis for decisions regarding the continuation of the guarantee program.³

Guarantees should only be issued on terms that ensure that the risks of the guarantee can be identified. For example, all guarantees should be limited in time and cover a limited amount. This is crucial to facilitate an analytical approach to the issuance and risk management of guarantees.

At the operational level there are important questions relating to contract design that must be solved. Often these questions affect the risk position of both the guarantor and the borrower. As noted in Section 2, using partial guarantees as a tool for risk sharing can reduce incentive conflicts. This leaves part of the risk with the lender and thereby increases the lender’s interest in controlling the project in a sound way. Therefore full guarantees should be used only in exceptional cases, where it is not feasible to transfer any credit risk to the lenders.

In such cases, careful consideration of whether a guarantee is the best instrument to use is typically warranted. In particular, if the project is considered highly risky, it may be more appropriate to use regular budget funds instead.

Many other aspects must be considered in order to formulate contracts that limit the government’s risk exposure to what is justified given the policy objectives involved. The limited scope of this report prevents us from going into a detailed discussion of contract design, however.

Finally, to support systematic decision-making and a setting of fees the government should establish procedures for cost estimation and pricing of guarantees, including clear guidelines regarding what part of the government that should be responsible for setting fees. We return to the pricing issues in section 4 and to the organisational aspects in Section 5.

Reporting of guarantees

A sound governance system must also have adequate rules for reporting of guarantees. The value of guarantee commitments should be acknowledged in the government’s budget reports and accounts and steps should be taken to ensure that actual resources are available if and when the guarantee is triggered.

As noted above, budget transparency and budget stability can be improved by requiring that an explicit fee is charged for all government guarantees and that the fee is included as a budget expenditure item in cases where the recipient of the guarantee does not have to pay the fee. However, circumstances will change over time so that the ex ante fees assembled no longer cover the risks of the guarantee portfolio. Consequently, the government must consistently monitor the expected losses and risks in the outstanding guarantees and be prepared to take adequate steps in case the

expected losses increase. In some cases it may be possible to raise the fees, but in general the government must be prepared to shoulder the costs of an outcome worse than expected. It is thus essential that information about the status of the guarantee portfolio is brought to the attention of policy makers so that necessary adjustment in other expenditures or revenues can be made.

It may also be the case that the reservations made for future losses turn out to be too big. If so, money should be transferred from the guarantee reserves to the general budget. However, a potential problem in this case is that an improvement that turns out to be temporary is used as an excuse to take money out of the fund. Reserve funds should thus be managed with a long-term perspective to avoid misuse.

Public accounting systems generally treat guarantees as off balance sheet items, which are not recognized as liabilities.⁴ However, information about the nominal value, expected value and nature of guarantees should be published, for example, as notes to financial statements or as a separate report, ultimately to the parliament. Reports should capture all government guarantees in order to give as complete a picture of the government’s risk position as possible, to support informed decisions and efficient risk management.

Because it is sometimes extremely difficult to accurately measure the value of guarantees, it is informative to describe also the terms and recipients of the guarantees and not just give figures on estimated present values. This allows external parties to make qualitative assessments of the government’s commitments. In particular if there is great uncertainty about the extent of the government’s guarantee commitments, investors will require risk premiums on the government’s regular borrowing in excess of what is fundamentally justified. Then, accurate and trustworthy reporting may reduce the government’s borrowing costs by dispelling this uncertainty.

Improved information standards can therefore be seen as an opportunity for the government, not as a burden.

Conclusions

A guarantee is a commitment of government resources. Consistency therefore requires that guarantees are issued under the same rules and procedures that govern other uses of government resources. This means, in particular, that guarantee issuance should be integrated into the budget process. The cost of the guarantee should be disclosed. A corresponding fee should be charged ex ante and resources should be set aside to cover future costs. The fee can be charged from the recipient or as an intra-government budget item in cases where the guarantee is to be subsidised. Guidelines should state accepted situations where guarantees can be used and require a comparison between guarantees, direct lending and other forms of support.

The current value and nature of guarantees should be reported publicly. Such a system supports transparency and sound decision-making and encourages use of guarantees only in situations where other forms of support are less efficient.

IV. Valuation and pricing of government guarantees