Guarantees 

Download

Instrument Category

  • Other Financing Mechanisms

Other ınstruments ın the same Category

Revolving funds
Blended finance vehicles
On-bill financing / On-bill repayment schemes
Asset-backed securities (ABS)
Crowdfunding

Relevant case study

Description 

A guarantee is a credit-enhancement mechanism for debt instruments (loans or bonds). It represents a contractual promise by the guarantor to pay the principal and/or interest to the lender the amount that has been guaranteed in the event of a default. This provision is important as it meaningfully de-risks investments, enabling private sector financiers to provide funding for vital projects. Studies have shown that default rates on guarantee-backed transactions are relatively low, indicating that in some cases perceived risks outweighs real risk, and that the provision of guarantees can consequently lower costs for the public sector to meet development objectives.

Guarantees can be applied to a variety of situations to improve a borrower’s access to capital. For example, many international development organisations offer partial credit guarantee (PCG) or partial risk guarantees (PRG). Partial credit guarantees provide lenders and investors with comprehensive credit cover on the portion of the loan or bond that has been guaranteed by the international development organisation in the event of a default. Partial risk guarantees cover lenders against nonpayment by the borrower caused by political risks events. Another application is public credit guarantee schemes (PCGS) which can be used by governments to unlock finance for diverse objectives, including loans to small and medium enterprises (SMEs). In this context, the scheme provides third-party credit risk mitigation to lenders by absorbing a portion of the losses in case of default, typically in return for a fee.

Enabling Conditions and Key Considerations 

  • Clear project proposal. Lenders and guarantors need to assess a project’s technical and financial feasibility prior to approving a guarantee. A well-prepared project proposal, with clear purpose, scope, and outcomes that demonstrate its financial viability can enhance the project’s attractiveness and therefore the likelihood in securing a guarantee.
  • Existing working relationships. The presence of a prior working relationship contributes significantly to the overall confidence and cooperation required to secure a guarantee. A history of successful collaboration or previous financial transaction builds confidence in the lender and/or guarantor on the borrower’s reliability and competence and can be extremely helpful during the negotiation process.
  • Consistency in regulatory frameworks. A consistent legal environment provides a secure foundation for guarantors, borrowers, and lenders, on contractual obligations and dispute mechanisms. This predictability enhances the overall risk assessment for the guarantor and the investor, instilling confidence in the feasibility of the guarantee arrangement.

Potential Challenges

  • Potential complexity in aligning expectations of parties involved. Guarantees add complexity to a loan transaction by including at least one additional party into the arrangement. It would therefore be critical to align the interests and expectations of the multiple parties involved. This includes aligning on aspects such as the expected impact of the deal and how the impact will be measured, agreement on risk sharing layers, timelines for closing the deal, and overall long-term goals of each party.
  • Risk of moral hazards. A poorly designed guarantee scheme can increase the risk of moral hazards, given the risk of default has now been partially shifted onto the guarantor. For example, a borrower might be less cautious in project management or financial decisions, assuming the guarantor will cover the default. If these risks are not properly anticipated or managed appropriately, repeated defaults can affect the local government’s finances in the future. Clear contractual obligations, aligned incentives, and effective oversight can help deter parties from engaging in excessive risk-taking behaviour.

Potential Benefits 

  • Enhances creditworthiness. Guarantees can help enhance the creditworthiness of a debt instrument, such as a bond guarantee or a loan guarantee. By providing assurance that repayment obligations will be met even in adverse circumstances, guarantees make projects more attractive to lenders. This in turn can result in more favourable financing terms, such as lower interest rates or longer repayment periods.
  • Facilitates access to private sector lending. The presence of guarantees in a project can attract a wider pool of investors, including those from the private sector, who may have been hesitating to participate without the added assurance and layer of risk sharing. This in turn fosters investments in sectors that an investor may previously have not considered, such as green or sustainable projects for smart cities.

Sources/Additional Information

Case Study

Scroll to Top