NEWS – A working group constituted by the Reserve Bank of India (RBI) made certain recommendations to address issues relating to guarantees extended by State governments

WHAT CONSTITUTES A ‘GUARANTEE’?

• Contingent liability of a State, processed by an accessory contract, that protects the lender/investor from the risk of borrower defaulting
• Entity to whom the guarantee is given is the ‘creditor’, the defaulting entity on whose behalf the guarantee is given is called the ‘principal debtor’ and the entity giving the guarantee (State governments in this context) is called the ‘surety’
• State governments are often required to sanction, and issue guarantees, on behalf of State-owned enterprises, cooperative institutions, urban local bodies and/or other State-governed entities, to respective lenders
• The latter could be commercial banks or other financial institutions. In return, the entities are required to pay a guarantee fee to the governments
• The Working Group has suggested that the term ‘guarantee’ should be used in a broader sense and include all instruments, by whatever name they may be called, if they create obligation on the guarantor (State) to make a payment on behalf of the borrower at a future date

WHAT ABOUT ACCORDING GUARANTEES?

• Government guarantees should not be used to obtain finance through State-owned entities, which substitute budgetary resources of the State Government
• State should not be allowed to create direct liability/de-facto liability on the State
• Recommends adherence to the Government of India guidelines that stipulate that guarantees be given only for the principal amount and normal interest component of the underlying loan
• Loans must not be extended for external commercial borrowings, must not be extended for more than 80% of the project loan and must not be provided to private sector companies/ institutions

WHAT ABOUT RISK DETERMINATION?

• States assign appropriate risk weights (indicative of the holding the lender should ideally have to adjust the associated risk) before extending guarantees + categorisation could be high, medium or low risk
• Ceiling on issuance of guarantees as “desirable.”
• Should a guarantee be required to be invoked, it could lead to significant fiscal stress on the State government
• To manage the potential stress, for incremental guarantees (additional guarantees) issued during a year, it proposes a ceiling at 5% of Revenue Receipts or 0.5% of GSDP — whichever is less

WHAT ABOUT DISCLOSURES?

• Apex banking regulator may consider advising banks/NBFCs to disclose the credit extended to State-owned entities, backed by State-government guarantees
• Availability of data, both from issuer and the lender, the report states, may improve the credibility of the data reported by the State government