RBI guidelines on State guarantees

Source-This post is based on the article “RBI’s guidelines on State ‘guarantees’ on borrowings ” published in “The Hindu” on 27th January 2024.

Why in the News?

A working group formed by the Reserve Bank of India (RBI) put forth recommendations to tackle issues regarding guarantees provided by State governments.

What defines a ‘state guarantee’?

1) A state guarantee is a commitment by a government entity, like a state government, to cover the repayment of a debt or fulfil an obligation if the borrower or obligated party cannot do so.

2) The recipient of the guarantee is the ‘creditor,’ the defaulting entity on whose behalf the guarantee is given is called the ‘principal debtor (State owned enterprises, cooperative institutions, urban local bodies in case of state borrowing) and the entity providing the guarantee (State governments in this context) is the ‘surety/guarantor‘

What are the recommendations of the working group?

The RBI working group has pointed out that while guarantees may seem safe during stable times, they can create significant financial risks and stress for the government during economic downturns. This could lead to unexpected cash outflows and higher debt levels. To address this issue, the following recommendations have been made:

1) Expanded Definition of Guarantee– The Working Group proposes a broader definition of ‘guarantee’ to encompass all instruments which create an obligation on the guarantor to pay. There must not be any distinction between conditional or unconditional, financial or performance guarantees while evaluating fiscal risk.

2) Government Guarantee Restrictions– RBI working group has recommended certain restrictions which are as follows-
a. Government guarantees should not be used to obtain finance through state owned entities like State owned enterprises, cooperative institutions, urban local bodies.
b. Government guarantees should not create direct liability/de-facto liability on the State.
c. Guarantees must be given only for the principal amount and normal interest component of the underlying loan.
d. Guaranteed 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.

3) Risk Determination–
a. States should assign appropriate risk weights like high, medium or low risk before extending guarantees.
b. The states must also manage the potential stress which will emerge in case of invocation of guarantee. Hence, RBI working Group has proposed that the maximum incremental guarantees (additional guarantees) issued during a year should be capped to either 5% of Revenue Receipts or 0.5% of GSDP- which ever is lesser.

4) Disclosure of Guarantees- The RBI Working Group has proposed that the RBI may consider advising banks/NBFCs to disclose the credit extended to State-owned entities, backed by State-government guarantees. The Group has also called for a comprehensive database to capture all extended guarantees.

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