UNCTAD Virtual Institute for Trade and Development
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Sovereign Asset and Liability Management: An E-Learning Training Course
I. The Accounting/Financial Balance Sheet
II. Sovereign Asset and Liability Management Framework: Approach I
III. Sovereign Asset and Liability Management Framework: Approach II
IV. Sovereign Asset and Liability Management Framework: Approach III
V. Contingent Liabilities
i. Explicit Liabilities: Guarantees
ii. Implicit Liabilities: Financial Sector Bailouts and Natural Disasters
iii. Managing and Mitigating Contingent Liabilities



Explicit Liabilities: Guarantees

“In terms of incidence, by far the most widespread form of CL is guarantees, particularly loan guarantees, which exist in virtually all countries” (Cebotari, 2008).  As stated earlier, one of the reasons guarantees are such a popular financing tool is that their true costs are often shielded from the public and normal budgetary process and appear to be the cheapest source of financing.  Guarantees are often viewed as a “free lunch” in the sense that policymakers can use them to further policy and program objectives without having to account for them or pay for them up front.  However, evidence indicates that guarantees can be far more costly to the government in the end should they come due than direct lending and other more transparent means of financing. 

“A comparison between credit guarantees and direct lending has to consider the relative financing costs and how they are divided between the borrower and the government.  But there are other differences between guaranteed debt and on-lending that may be equally important. Some of these differences are related to the fact that the government allows an external party to borrow against the government’s balance sheet.  Others have to do with the fact that a guarantee involves three parties – the borrower, the lender, and the guarantor–whereas a credit only has two–the borrower and the lender.  The parties may have different incentives, as well as different comparative advantages.  These additional features are likely to affect the relative costs and risks of guarantees and direct lending” (OECD, 2005).

One of the inherent problems and reason for their cost to sovereigns, is the inability to transfer or share risk from guarantees.  Sovereigns should transfer risk to the private sector, if possible, or at a minimum, share the risk with the recipient of the guarantee. If there are no incentives for the recipient of the guarantee to prevent it from coming due, the likelihood the guarantee will come due will increase due to moral hazard.  As such, guarantee recipients should bear some cost of the guarantee whether it is in a fee to receive the guarantee or having the guarantee be of lesser value than the potential loss.  “For instance, EU state aid rules prohibit the government from guaranteeing more than 80% of any loan, in Canada the government limits its guarantees to at most 85%, while the United States’ Small Business Administration also guarantees up to 85% of the loans to SMEs” (Cebatori, 2008).

The primary methods for pricing guarantees:

  1. Implicit pricing guarantee
  2. Option models
  3. Simulation models

Determining the value of guarantees and what their true cost is can be difficult.  “If a guarantee has the pledge of the full faith and credit of the sovereign underwriting the guarantee, the guarantee should be equivalent to the value of risk free bonds.  The implicit market value of a guarantee can be calculated as the difference between the market value of a risk-free government bond and the market value of bonds issued by the potential recipient of the guarantee.  This implicit valuation methodology provides the market value of the guarantee and can be used to set market-related fees.  The market value comprises the expected or risk-neutral value of the guarantee.  But in addition, it will most likely include a risk premium, which reflects the markets’ required premium for being exposed to unexpected contingencies” (OECD, 2005).

Guarantees are similar to put options as they allow the entity which will receive the benefit of the guarantee the right, but not an obligation, to exercise the value of the guarantee at a particular price.  Whether or not the guarantee is exercised will depend on market conditions and if the guarantee has greater value than the actual asset.  For example, if the government provides a farmer a guarantee on the price of a particular crop at 100 Euro per kilogram and the market price of the crop is only 90 Euro per kilogram, the recipient of the guarantee will exercise the guarantee.  This concept of option pricing and option pricing models can be applied to other CL such as: the guarantees on the debt of SOEs or subnational units. 

 “A third approach is to build a simulation model.  This method is fundamentally similar to option pricing.  The purpose of a guarantee simulation model is to generate a distribution of losses from the guarantee to the government.  This distribution can be used to calculate the expected cost of the guarantee and to calculate risk measures compiled as the maximum loss that will occur within a given probability.  Building a simulation model applied to guarantees requires a specification of the processes that determine the evolution of the asset value of the guarantee.  A simulation model can be designed to take many considerations into account compared with the more restrictive assumptions of option models.  In this sense the simulation approach is more flexible but also more demanding” (OECD, 2005). 

“The choice of method depends generally on the availability of data and the cost of the method.  Valuations based on market data are used when the borrower issues debt quoted in the market or when it is relatively easy to find comparable entities that do so.  If these are difficult to find, simulation methods are frequently used instead, but these may be time consuming and expensive to develop, and hence may be cost effective only if the guaranteed amounts are large.  Otherwise, if the guarantees are relatively small, an option pricing model may be a good substitute (Hagelin, 2003). In cases where data are so limited that neither option pricing or simulations are feasible, a simple classification of guarantees into high, medium, low, or very low default risks (with associated probabilities of default)–based on available information or educated guesses–could be employed to assess expected losses.  Any reasonable approach will produce better estimates of the cost of loan guarantees than the cash-based approach that will always assume zero cost in the budget year” (Cebotari, 2008).

For more on valuing CL, please see Section V. of the World Bank report Risk Management of Contingent Liabilities Within a Sovereign Asset-Liability Framework".











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