RBI GUIDELINES ON STATE GUARANTEES 

2. About 'Guarantee'

A 'guarantee' is defined as a contingent liability of a State, formalized through an accompanying contract. This arrangement serves to safeguard the lender or investor against the potential default risk of the borrower. The guarantor commits to being accountable for the debt, default, or failure of the borrower.

Key Parties Involved:

• • Creditor: The party receiving the guarantee.
  • Principal Debtor: The entity for whom the guarantee is provided, and who may face default.
  • Surety: The entity offering the guarantee, typically State governments in this context.
• If party A supplies goods or services to party B, and B fails to make the agreed payment, B is in default and liable for the debt. At this point, party C intervenes, pledging to cover B's default. This act constitutes a guarantee.
• The report from the RBI working group emphasizes that while guarantees may seem harmless during favourable economic conditions, they can pose substantial fiscal risks and burden the State during challenging times. This situation can lead to unforeseen cash outflows and an increase in debt.
• State governments often authorize and issue guarantees on behalf of various entities such as State-owned enterprises, cooperative institutions, urban local bodies, or other State-owned entities. These guarantees are extended to diverse lenders, including commercial banks and financial institutions.
• In return for these guarantees, entities are obligated to pay a guarantee fee to the State governments. This dynamic plays a crucial role in the financial landscape, impacting both the guarantor and the entities receiving the guarantees.

3. Definition of 'Guarantee'

The Working Group, constituted by the Reserve Bank of India, proposes a comprehensive redefinition of the term 'guarantee.' According to their recommendations, the term should be expansively interpreted to encompass all instruments, regardless of nomenclature, that impose an obligation on the guarantor (State) to make a payment on behalf of the borrower in the future.

1. The suggested definition broadens the scope to include any financial instrument or contractual arrangement, irrespective of its specific designation, as long as it entails a commitment from the guarantor to fulfil a payment obligation on behalf of the borrower.
2. The proposed definition removes distinctions based on conditions, categorizing guarantees as conditional or unconditional, and whether they pertain to financial or performance aspects. This uniform approach is intended to assess fiscal risk without differentiating between the various forms of guarantees.
3. Central to the definition is the aspect of creating an obligation for the guarantor to make payments on behalf of the borrower at a future date. This emphasizes the forward-looking nature of guarantees, where the guarantor commits to financial responsibility for potential future events.

4. Guidelines on Government Guarantees

The Working Group, established by the Reserve Bank of India, has put forth crucial recommendations regarding the utilization of government guarantees. These guidelines aim to ensure the responsible and prudent use of guarantees to safeguard the financial interests of State governments.

• The Working Group strongly advises against the use of government guarantees to secure finance through State-owned entities. Such practices, which substitute budgetary resources of the State Government, are discouraged to maintain fiscal discipline.
• A key recommendation emphasizes that government guarantees should not lead to direct or de facto liability on the State. This precautionary measure is designed to prevent undue financial burdens on the State.
• The Working Group advocates strict adherence to the Government of India guidelines. These guidelines specify that guarantees should only cover the principal amount and the normal interest component of the underlying loan. This measured approach helps mitigate fiscal risks associated with guarantee commitments.
• Guarantees are advised not to be extended for external commercial borrowings. Additionally, the Working Group recommends restricting guarantees to not exceed 80% of the project loan. Furthermore, the extension of guarantees to private sector companies or institutions is discouraged.

5. Risk Assessment and Ceilings on Guarantee Issuance

The Working Group has outlined specific measures for determining and managing risks associated with the extension of guarantees by State governments. These recommendations aim to ensure a judicious approach to guarantee issuance and minimize the potential fiscal stress on State governments.

• States are advised to assign appropriate risk weights to guarantees, indicating the level of risk associated with each. The suggested categorization includes high, medium, or low risk. The assessment should also take into account the historical record of defaults, providing a comprehensive evaluation of the associated risks.
• The risk determination process must incorporate the past record of defaults. This historical perspective contributes to a more nuanced understanding of the potential risks associated with extending guarantees.
• The report underscores the desirability of imposing ceilings on the issuance of guarantees. Recognizing that invoking guarantees could lead to significant fiscal stress, the imposition of ceilings serves as a preventive measure.
• For incremental guarantees issued during a year, the Working Group proposes a ceiling at 5% of Revenue Receipts or 0.5% of GSDP (Gross State Domestic Product), whichever is less. This measure is intended to manage and control the potential fiscal impact of additional guarantees, ensuring responsible fiscal management.

6. Enhanced Disclosure Practices for State-Government Backed Credits

The Working Group has proposed measures to improve transparency and data credibility regarding credit extended to State-owned entities backed by State-government guarantees. These recommendations are directed towards enhancing disclosure practices within the banking sector.

• The apex banking regulator is suggested to consider advising banks and non-banking financial companies (NBFCs) to disclose information related to credit extended to State-owned entities supported by State-government guarantees. This advisory aims to promote transparency in financial reporting.
• The report highlights that data availability from both the issuer (State government) and the lender can contribute to enhancing the credibility of reported data. By ensuring comprehensive and accurate information, stakeholders can make informed decisions.
• The Working Group advocates for the creation of a proper database that captures details of all extended guarantees. This centralized repository would serve as a comprehensive source of information, facilitating effective monitoring and management of guarantee-related data.