Loan loss reserve (LLR)

Loan-loss reserves (LLR) serve as an effective credit enhancement tools, strategically bolstering credit risk profiles of lenders or investors to secure better debt repayment terms.
Download

Instrument Category

  • Government Funding

Other ınstruments ın the same Category

National government transfers
Tax incentives for smart city development
Land pooling
Asset recycling

Relevant case study

Description

Loan-loss reserves (LLR) are funds earmarked as a financial safeguard to mitigate potential future losses on loans caused by borrower defaults. Such funds provide partial risk coverage to lenders as the reserve will cover a pre-specified amount of loan losses. They can serve as an effective credit enhancement tool, strategically bolstering credit risk profiles of lenders or investors to secure better debt repayment terms. By acting as a financial safety net, LLRs can help enhance credit risk profiles and pave the way for more inclusive financing opportunities that can drive sustainable development and innovation.

In an LLR program, a government agency could partner with a financial institution to modify its underwriting criteria and accept more risk than it would otherwise, so that the financial institution is more comfortable with providing loans to new sectors or at lower interest rates and longer repayment periods. LLR proves particularly beneficial in scenarios where financial institutions can make numerous small loans for projects, such as retrofitting for energy efficiency improvements. With a small amount of state funds set aside as reserves to safeguard against risks, the private and public sector can partner to create a loan portfolio that provides small-scale financing.

Through LLRs, state governments or local municipalities can widen financing access for new smart city solutions such as energy efficiency upgrades, or small-scale renewable energy projects. For instance, LLRs could underpin a clean energy loan program jointly managed by the government and partnering financial institutions. The credit enhancement feature of LLRs could lead to more favourable loan conditions, such as reduced interest rates or longer repayment periods. Moreover, LLRs play a crucial role in broadening financial access by allowing partner financial institutions to adjust their underwriting criteria to accommodate a higher risk threshold, which could be particularly beneficial for smart city projects where lenders could be unwilling to lend due to limited experience in such projects or a limited understanding of the technologies involved.

Enabling Conditions and Key Considerations

  • Competitive procurement process. LLR programs should involve a competitive procurement process to identify the right financial institution partner to support. This process includes creating a comprehensive request for proposal from the financial institution that should include information on the financial institution’s loan terms, preferred LRR structure and risk-sharing formula, loan underwriting guidelines, loan marketing capacity, loan management capacity, staff, and qualifications.
  • Structuring an LLR. LLRs take a “portfolio approach,” so that governments setting up LLRs do so on the basis of the entire portfolio of loans they support. For example, a 5% loss reserve on a $60 million loan portfolio means that the size of the loss reserve is $3 million. During the structuring, governments can set the size of the reserve to be higher than the portfolio’s estimated loan loss. For example, if estimated losses are 1.5% of the portfolio, the LLR can be set at 5-10%, depending on the negotiations between the government and the financial institution partner. The final risk-sharing formula must be agreed between the government and the financial institution carrying out the lending, as the LLR does not remove the risk from the financial institution but reduces it. For example, the target market could be a portfolio consisting of a large number of small transactions, up to hundreds or thousands of loans to individual lenders. First losses can be covered by the LLR, up to the limits of the LLR and according to the agreed risk-sharing formula.

Potential Challenges

  • Risk of moral hazards. Poorly designed LLR programs with inadequate oversight can elevate the risk of moral hazard behaviour on the part of partner financial institutions, and an increase in non-performing loans if loans are disbursed without the necessary safeguards and checks. Establishing clear underwriting guidelines, contractual obligations and implementing effective oversight mechanisms are crucial in deterring parties from engaging in excessive risk-taking behaviour.
  • Challenges in aligning interests among stakeholders. Structuring LLRs can pose a challenge in terms of aligning interest among the various stakeholders involved. For example, determining and negotiating the risk-sharing formula and terms between the state government and financial institution can be a complex process, and require careful consideration to strike a balance between maintaining financial stability while broadening access to capital.
  • Lack of public sector experience in designing LLRs. Local governments may have limited experience with such financial mechanisms, which can lead to challenges such as overestimating the necessary reserves, thereby unnecessarily tying up funds, or underestimating, which risks insufficient coverage for loan defaults. Local governments may also face hurdles in establishing the collaborative frameworks necessary for LLR programs, including aligning objectives with private sector partners, managing regulatory compliance, and ensuring transparent and effective governance structures. These challenges necessitate a careful approach to capacity building, stakeholder engagement, and perhaps the adoption of best practices from more experienced entities or sectors to ensure the successful implementation and management of LLR programs.

Potential Benefits

  • Support new sectors or types of financial products. As a credit enhancement mechanism, LLRs can help incentivise financial institutions to offer more favourable terms on a loan, such as lower interest rate and longer loan periods. This enables financial institutions to expand their credit facilities to new sectors that would previously not have met their risk criteria, or to pilot new types of financial products.
  • Facilitate access to capital for smaller projects. The portfolio approach in a LLR structure, typically consists of thousands of smaller loans. This ensures diversification within the portfolio and helps provide access to capital for smaller loan projects that could be overlooked by more traditional financing structures, thus fostering a more inclusive and impactful financial services landscape.

Sources/Additional Information

Case Study

Scroll to Top