A Reserve Bank working group has suggested that state governments should charge a minimum fee for guarantees extended by them on loans taken by their enterprises, local bodies, and cooperative institutions.
Keeping in view the inherent risks associated with the guarantees extended by the state governments on their fiscal health and to the banking system, it was decided during the 32nd Conference of the State Finance Secretaries held in July 2022 to set up a Working Group, the RBI said in a statement on Tuesday.
The Reserve Bank has released the 'Report of Working Group on State Government Guarantees' on its website.
State governments are often required to sanction, and issue, on behalf of various state enterprises, cooperative institutions, urban local bodies, and other state-owned entities, guarantees in favour of their lenders which are generally commercial banks or other financial institutions.
There is a specific ceiling of 0.5 per cent of GDP for additional guarantees to be issued by the Central Government in a financial year as stipulated under the FRBM Act.
A guarantee is a type of contingent liability protecting the investor/ lender from the risk of default by a borrower. Guarantees are usually sought when the investors/lenders are unwilling to bear the risk of default.
"State Governments may consider charging a minimum guarantee fee for guarantees extended and additional risk premium may be charged based on the risk category and the tenor of the underlying loan," is on the major recommendation of the group.
The panel has also suggested that state governments may consider fixing a ceiling for incremental guarantees issued during a year at 5 per cent of Revenue Receipts or 0.5 per cent of Gross State Domestic Product, whichever is less.
The group also suggested that the word ‘Guarantee’ should include all instruments, which create an obligation, contingent or otherwise, on part of the state government.
Further, the purpose for which government guarantees are issued should be clearly defined.
"There should not be any distinction made between Conditional/Unconditional, Financial / Performance guarantees as far as the assessment of fiscal risk is concerned as all of these are in the nature of contingent liability that might get crystallized on a future date," is another suggestion made by the panel.
It further suggested that state governments should classify the projects/ activities as high risk, medium risk and low risk and assign appropriate risk weights before extending guarantees for them.
The RBI has, in the past, flagged the issue of bank finance to government-owned entities, often in violation of the prudential guidelines.
"Since most of these loans are backed by explicit guarantees offered by the state governments concerned, it may be necessary for the states to take into consideration the risk of guarantee being invoked," the report said.
The lending bank/NBFC should also undertake a comprehensive assessment of the loan proposal without taking comfort from the guarantee extended by the state.
The Working Group comprised representatives from Union Finance Ministry; Comptroller and Auditor General of India (CAG), Andhra Pradesh, Haryana, Karnataka, Odisha and the Union Territory of Jammu & Kashmir was constituted.