Fixing the Misunderstanding about the Proposed Reform of the Credit Guarantee Program

YAMORI Nobuyoshi
Faculty Fellow, RIETI

Enhancement of support for SMEs as the starting point of bold reform

In February 2017, the Cabinet approved and forwarded to the Diet a bill to amend the Small and Medium-sized Enterprise Credit Insurance Act for the facilitation of business improvement and development at small and medium-sized enterprises (SMEs). This would mark the first major reform of Japan's credit guarantee program since two major changes—a shift from flat-rate premiums to risk-based premiums (2006) and the introduction of a risk sharing system (2007)—were implemented in line with a set of recommendations put forward by the Council for Small and Medium Enterprise Policy in 2005.

The council's working group on SME finance (hereinafter "SME Finance WG"), which served as a forum to discuss reform measures proposed this time, was set up in response to the Japan Revitalization Strategy 2015 (June 2015), which called for reconsidering the operation of the credit guarantee program to spur banks' efforts to help SMEs improve business and productivity. Here, let me emphasize that, as symbolized by this fact, the starting point of this reform debate was not the financial problem of the program but the enhancement of SME support.

In December 2016, after an approximately one-year-long debate, the SME Finance WG put together a report entitled "Toward the Establishment of a Sustainable Credit Guarantee System to Support the Development of SMEs and Micro Businesses." This title also clearly indicates the nature of the reform.

The bill almost entirely reflects the ideas contained in the report, and it is expected that relevant government guidelines—such as those of the Financial Services Agency (FSA) and the Small and Medium Enterprise Agency (SMEA)—will be revised in line with the report. Therefore, in what follows, I would like to outline the essence of the SME Finance WG's report and dispel any misconceptions about the proposed reform.

Risk sharing from a broader perspective including both guaranteed and non-guaranteed loans

While acknowledging that the credit guarantee program will continue to play an important role in SME finance, the report clearly sets out the direction of reform. Specifically, it calls for changing the way in which credit guarantee corporations (CGCs) and banks share the risk of SME financing, thereby encouraging banks to implement appropriate ongoing monitoring and business management support while continuing in lending based on business potential.

In considering changes to the risk sharing between CGCs and banks, the SME Finance WG discussed a reduction in the CGC coverage from the current 80% as a possible reform option but dropped the idea in the end. It concluded that seeking to achieve appropriate risk sharing across the entire scope of loans—whether with or without guarantees—in substantive terms on a debtor-by-debtor basis would be more effective than lowering the guarantee coverage ratio uniformly, from the viewpoint of supporting SMEs.

For instance, consider the case of Company A, which has outstanding loans worth 100, of which 50 are in CGC-guaranteed loans (80% coverage) and the remaining 50 in ordinary, non-guaranteed loans. In the event of default, the CGC would cover 40% of the resulting loss and the lender would bear the remaining 60%. That is, the bank's share of the credit risk is 60%.

Now, suppose that Company A's business performance deteriorates, making it difficult for the bank to assume the risk as it used to. Based on the risk sharing approach proposed in the report, reducing the ratio of non-guaranteed loans to 20% would reduce the bank's share of the credit risk to 36%. If Company A has not lost its viability, the bank would be able to continue to lend to the company by using the credit guarantee program even in difficult business environments. Conversely, applying a uniform share of burden could result in the bank's refusal to provide loans to Company A in the just described situation.

As such, the idea proposed in the report is to adjust the ratio between guaranteed and non-guaranteed loans flexibly in accordance with the needs of SMEs at various stages of their life cycle and the situations they face, i.e., "coordinated guarantees" in short.

However, such a flexible framework could cause a moral hazard on the part of banks. If main creditor banks free ride on the CGCs' supportive stance and abandon their responsibility, the proposed reform would backfire. It is main creditor banks' role to support their client companies when their business is down. The focal question hereafter is whether it is possible to adjust the ratio between guaranteed and non-guaranteed loans in an optimal way in accordance with the circumstances, not of banks, but of SMEs.

Roles of credit guarantees in dealing with SMEs at various stages of their life cycle

The report sorts out ideas on the usage of credit guarantees to better accommodate the needs of SMEs depending on the stage in their life cycle.

It calls for expanding credit support measures for SMEs in a startup stage and those undergoing a restructuring process. Specifically, the report recommends the following: (1) raising the maximum startup loan value eligible for 100% coverage from the current 10 million yen to 20 million yen; (2) creating a new guarantee facility for SMEs under restructuring to assist them with their business succession or in making an orderly exit; and (3) raising the maximum micro-business loan value eligible for 100% coverage from the current 12.5 million yen to 20 million yen.

In contrast, the report calls for cutting down on credit support for those in a growth stage, noting that as businesses grow, they should reduce—and eventually eliminate—reliance on credit guarantees by securing ordinary bank loans.

As such, the proposed reform seeks to address the current problematic situation where SMEs continue to rely on credit support even after they have reached a stage where they can access bank loans based on their own creditworthiness, while realizing sufficient credit supply to those truly in need.

Here I would like to draw attention to the fact that all of the proposed reform measures have been developed from the standpoint of enhancing support for SMEs. For instance, the SME Finance WG's report calls for an increase in the maximum micro-business loan value eligible for 100% coverage, as mentioned above. The report says that the intention behind this measure is to enable small enterprises to reconstruct their business by facilitating their access to new loans. Therefore, if there are any banks that see the proposed expansion of the credit guarantee program as a tool to enable their troubled small business borrowers to postpone their repayment obligations, they are taking it all wrong. If an application for the use of the expanded scheme is made with such an intent, CGCs would definitely urge the applicant to reconsider. Putting it the other way around, it is one of the roles expected of CGCs to check whether the expanded credit guarantee scheme is used for its intended purpose, i.e., to help small enterprises to emerge from their difficulties.

Establishing an emergency response scheme with a specific time limit

The emergency credit facilitation scheme introduced in the aftermath of the collapse of Lehman Brothers is deemed to have significantly contributed to the protection of SMEs. However, it took more than five years for Japan to put a complete end to this scheme, whereas similar schemes in other countries were terminated within a maximum of about two years.

While such exceptionally generous emergency measures are in place, the SMEs tend to lose motivation to improve their business. The longer they remain spoiled, the more difficult it will be to return to normalcy. Thus, the SME Finance WG's report calls for creating a new emergency facility that would be applicable for a predetermined fixed period to achieve two ends: 1) providing firm support to companies in the event of a major economic crisis, and 2) preventing the extension of the exceptional scheme without good reason.

Another important change proposed in the report is the reform of Safety-net Guarantee No. 5, a scheme targeted at SMEs in structurally declining industries. Specifically, it calls for lowering the guarantee under this scheme from the current 100% to 80%, the same as in ordinary, non-safety net schemes. Again, the aim of this change is not to reduce the role of the credit guarantee program but to address the current problematic situation, where banks are not providing sufficient support and borrower SMEs are backpedaling in their self-help efforts, both spoiled by the 100% coverage scheme, resulting in little progress in much needed business restructuring.

Heading in the same direction as the government's financial administration

In recent years, the government's financial administration has been urging banks to make proper assessment of their corporate customers' business operations and growth potential (business viability assessment) rather than relying on collateral and guarantees in making lending decisions. Using the terminology of financial administration, we can describe the proposed reform of the credit guarantee program as an instrument designed to "increase incentives for banks to focus their efforts on business viability assessment."

Therefore, the proposed reform and the government's financial administration are heading exactly in the same direction. One piece of evidence for this is the inclusion of the following statement in the FSA's Strategic Directions and Priorities 2016-2017: "With regard to the credit guarantee program, a review is currently underway to reform the program with the aim of providing a greater incentive for banks and CGCs to take more proactive steps to support companies on the premise of voluntary efforts on the part of the companies to improve their business, and we will engage in dialogue with banks to promote their efforts in line with such reform."

An accurate understanding of the relationship between business viability assessment and CGC-guaranteed loans is essential to ensuring appropriate use of the credit guarantee program. This is because there seems to be a misunderstanding in some quarters that the FSA is urging banks to reduce the use of the credit guarantee program, an idea based on misguided belief that business viability assessment and CGC-guaranteed loans are incompatible with each other.

Benchmarking of financial intermediation functions and credit guarantees

Such misunderstanding is not without reasons. For instance, a set of benchmarks introduced by the FSA in September 2016 to measure banks' performance as financial intermediaries include a "shift in lending policy away from an excessive reliance on collateral and guarantees in making loan decisions" as "Common Benchmark (3)," one of the three benchmark items applicable to all banks. Specifically, it measures the number of corporate clients to which the bank is extending loans based on business viability assessment and the amount of such loans.

However, what is important here is that business viability assessment is to make proper assessment of their corporate customers' business operations and growth potential. For instance, consider the case of a potential corporate borrower. After conducting detailed business viability assessment, the bank concludes that the company is reasonably viable but it cannot afford to take the entire risk on its own. Now, if the bank extends a CGC-guaranteed loan to the company by taking advantage of the credit guarantee program, this corporate borrower is counted as one to which the loan is made based on business viability assessment. On the other hand, if the bank rules out the possibility of using the credit guarantee program and decides not to support the company, it would be contributing to what the FSA calls "Japanese-style financial exclusion."

Also, among the optional benchmarks are the "proportion of those borrowers to which the bank is extending non-guaranteed loans as the main creditor among the local SME borrowers" and the "proportion of CGC-guaranteed loans in the total amount of loans to SMEs." Obviously, an increase in CGC-guaranteed loans has a negative impact on these benchmarks.

However, it is wrong to interpret them as the FSA implicitly urging banks to reduce the use of guaranteed loans. We must not forget that the SME Finance WG's report points to the need for Japanese banks to stop relying on credit guarantees in making loan decisions to companies in their growth stage. Those banks that have been using the credit guarantee program in making loans to borrowers that are credit worthy and do not require guarantees should use the benchmarks as a tool to reduce their excessive reliance on credit guarantees and shift to business viability assessment in making loan decisions. Meanwhile, the report calls for active use of credit guarantees in extending loans to startups and companies under restructuring. In addition, the FSA's benchmarks also include the "number of startup customers to which the bank is extending support," the "number of corporate customers to which the bank is assisting with business succession," and the "number of corporate customers to which the bank is assisting in making an orderly exit or changing business." Keeping these two factors in mind enables us to develop an accurate understanding. For instance, suppose that a bank finds it important to support local startups in cooperation with the competent CGC as a means to revitalize the local economy. In this case, what the bank should be doing is to choose the "number of startup customers to which the bank is extending support" as a benchmark to measure its performance and help its startup customers by making active use of CGC guarantees available for startup finance.

Here we can see the reason why the FSA has presented most of the benchmarks as options. In other words, in the case of a bank focusing on lending and support to startup customers, an increase in the use of credit guarantees could be a positive factor. In such a case, the bank should not choose the "proportion of CGC-guaranteed loans in the total amount of loans to SMEs" as a benchmark for its performance.

♦  ♦  ♦

Credit guarantees are a powerful tool to enable banks to fulfill their role as financial intermediaries. Undoubtedly, excessive use of credit guarantees does nothing to help increase the value of corporate customers. At the same time, however, it is also true that failure to use credit guarantees when necessary is also detrimental to the value of corporate customers. That is, the use of credit guarantees should be welcomed, when it is based on the bank's sufficient understanding of the customer's business operations and designed to facilitate the growth and development of the customer. I do hope that Japanese banks will make active use of the credit guarantee program and enhance support to SMEs in line with the intent of the proposed reform

>> Original text in Japanese

* Translated by RIETI.

May 29, 2017 Kinyu Zaisei Jijo

July 19, 2017

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