The government, on the other hand, doesn’t need to put money directly in the hands of the borrower. It saves resources and compensates only in cases where the borrower defaults and the chance of a recovery is bleak
The first loss guarantee is a mechanism whereby a third party compensates lenders if the borrower defaults. As the third party pays for the losses, it gives lenders confidence to give out loans. It is an insurance against a loss.
The government uses it to ensure that banks are not averse to lending because of the risks involved. For example, if the government provides 100% credit guarantee for loans of up to ₹1 crore. It means that if a bank lends up to ₹1 crore, and the borrower is unable to repay, the government will make good the entire loss. If the guarantee is for 20% of the loan, the government will compensate up to ₹20 lakh for a ₹1 crore loan.
This helps lenders to change underwriting policies and take more risk as there’s a guarantee on some portion of the loan. These schemes help putting money in the hands of the borrowers, who otherwise would not be able to raise money. They also help boosting liquidity, which can reduce the risk for debt mutual fund investors.
The government, on the other hand, doesn’t need to put money directly in the hands of the borrower. It saves resources and compensates only in cases where the borrower defaults and the chance of a recovery is bleak.
The centre has used this mechanism a few times in the past to boost confidence among lenders. It recently came up with a partial credit guarantee scheme that provided greater flexibility to public banks to buy bonds and commercial papers of NBFCs, boosting liquidity.
Similarly, the government also gave a credit guarantee on loans to micro, small and medium enterprises (MSME) as part of the stimulus package earlier in May, so that banks could give collateral-free loans to them.