Construction Finance EnablerBy Michael Wong

December2014

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Construction FinanceDefinition

A construction loan is any value added loan where the proceeds are used to finance construction of some kind. It is designed for construction and containing features such as interest reserves, where repayment ability may be based on something that can only occur when the project is built.

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Challenges: The financial products demanded by construction

contractors are often not offered to smaller contractors or offered at a price that is prohibitive

Uncertainty of the construction industry as reflected in the risk averse behavior of banks. Uncertainties include late completion of projects and non-compliance with technical requirements of the specific work

Payment culture of the public sector and private parties e.g late payments or non-payment altogether

BackgroundNeed for Construction finance

1. To purchase adequate machinery to meet tender requirements

2. To post a bid bond for access to the bidding process and/or a performance bond in case of successful tendering

3. For working capital 4. For access to a reasonable overdraft to pre finance

contracts until first payments are due5. For the ability to late payments for the completion of

work

Elements often required in construction financing:Pre-finance instrument/product: 15% - 20% of contract

value paid upfront (advance payment)Financial instrument for construction equipment:

Rentals and/or sale purchase agreements/leases3

Product Types (I)

A project-related bond is a written instrument executed by a bidder or a contractor, usually issued by a financial institution to assure fulfillment of the bidder’s or contractor’s obligations to a client.

Performance bonds/guarantee: a bond issued by a bank or other financial institution, guaranteeing the fulfillment of a particular contract.

i) It requires a cash deposit in the account of the issuing Bank without exposure to any risks (contractor has the cash equivalent in its account with the said bank)

ii) the bank has full benefits of charging an administrative cost and profit margin

Bid bonds: Guarantee provided to the project owner stating the capability to take on and implement a project once selected during the bidding process.

i) guarantee to the owner that you can do the job for a bid amount

Examples and key features

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Product Types (II)

(bid bond cont’d)ii) performance bond will be provided to back your work. iii) If the bid is won and the contractor backs out of the job or cannot post a performance bond, a claim can be made against the bid bond.

Advance payment bonds/guarantee: Guarantee supplied by a party receiving an advance payment to the party advancing the payment.

i) It provides that the advanced sum will be returned if the agreement under which the advance was made cannot be fulfilled.

Examples and key features

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Construction Finance (I)

North Dakota Housing Finance Loan Guarantee Program

Key Elements:Eligible Lenders : Any bank or trust company,

national banking association, savings and loan association, credit union or other financial institution authorized to transact business within the State which customarily provides service or otherwise aids in the financing of construction loans.

Guarantee fee: 0.5% of loan amount charged by NDHFA

Maximum guarantee: NDHFA will guarantee up to 50 percent of each construction loan made to an individual contractor.

Maximum loan amount: Construction loans provided by the Lender may not exceed 85 percent of the value of the housing unit (including lot and improvements) or total cost, whichever is less

Guarantee term: The Guarantee will terminate automatically 18 months after the origination of the construction loan.

Interest rate: Interest on advances must be collected no later than six (6) months after closing the construction loan and monthly thereafter. Lender reserves the right to renegotiate the construction loan interest rate every six (6) months.

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Construction Finance (II)

Indian Housing Loan Guarantee ProgramKey Elements:Firm Commitment Requirements: lenders must

submit plans and specifications for the construction or the rehabilitation work.

Timing.: Loan closing must occur after the receipt of a firm commitment and prior to the start of construction or rehabilitation.

Interest Rate: The interest rate on the loan must remain fixed throughout the term of the loan. Since the loan is fully guaranteed, the interest should reflect current market rates for permanent, rather than construction financing.

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Decomposition of Mutual Guarantee

Proposal 1) Partial Risk Guarantee

2) Group Lending

3) World Bank Project inclusion

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Introduction - PCGsDefinition: The terms partial credit guarantees (PCGs) defines a program/product which encourages financial institutions to provide loans to new sectors (e.g. agriculture, energy, health) or to new borrowers (e.g. MSMEs) and can encourage financial institutions to make longer-term loans

How PCGs Work: PCGs aim to lower the risk to the lender for a defined period by taking part of the risk of the counterparty, guaranteeing repayment of part of the loan upon a default event.

Intervention due to deficient enabling environment and information asymmetry. The combination of high requirements (eg collateral) due to perceived high risks, coupled with weak information and weak enforcement of credit contracts, stifles bank financing of SMEs in many of WBG’s client countries.

Countercyclical policy tool. Financial crises exacerbate the credit crunch for MSMEs. PCGs have been used as crisis-response tools in Korea, the EU, a.o

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Potential Impact of PCGs

Additionality – (i) capacity to provide additional finance that would not have otherwise been available, (ii) developmental impact and (iii) depth of financingIn Canada, 75% of guarantees are used by firms that would not have been able to obtain a loan otherwise - Ridding (2007) In Chile, the guarantee scheme increases the probability of small firms to get a loan by 14% - Larrain and Quiroz (2006)

Leverage - ability to ‘leverage’ PCG endowment on lending activityGood practice for ratio of outstanding guarantee commitments to the underlying funds of the PCG scheme is 6-7 times – Best (2005)

Wider welfare benefits include higher income, employment, and wages at small businesses – e.g. SBA-guaranteed loans in the US (Hancock, 2008)

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Introduction – Group Lending

How it worksGroup members guarantee the repayment of each

other’s loans. Collateral and co-signers are generally not used, peer

pressure and collective responsibilities generated by the group take their place

Functions typically performed by the bank staff are delegated to the borrower group i.e. peers screen clients, determining who to accept into their group;

Loan analysis by the lending institution is minimal, depending instead on peer assessments of each other’s businesses

Operational costs for group lending tend to be higher than those of individual lending, largely due to the additional time required for managing groups. High operational costs to the bank combined with relatively high risk require high revenues if the lending institution is to be sustainable

Group lending is considered riskier than individual lending (because the bank holds no collateral)

Group loans are usually more expensive and have higher rates of interest than individual loans.

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Approaches to Group Lending

How it works

The solidarity group model became very famous in 1976 after it was applied by the Grameen Bank. They aimed to address various social using the “Sixteen Decisions” framework

Later on this model was expanded to Latin America; focus more on credit provision. Solidarity group models in Latin America chose to retain loan approval and administration, using the already-existing operational systems developed for individual lending

Community-based organizations (CBO) differ from solidarity group in that they assume eventual graduation of their borrowers from the lending institutions. Therefore, the primary function of CBOs is to develop internal financial management capacity of the group in order to create a mini-bank, independent of the lending institution, owned and managed entirely by the poor.

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Approaches to Group Lending

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Group Lending Methodology

i. Grameen Group Lending Methodology

Source: http://grameenresearch.org/grameen-group-lending-model/

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Group Lending Methodology

ii. Banco Sol

Banco Sol offers credit, savings, and a variety of insurance products. Their initial loan offering was based on Grameen-style joint-liability lending, offering a maximum of $3,000 per client to groups of three or four individuals withAt least one year of experience in their proposed

occupation.Using dynamic incentives, the size of the loan is

gradually increased based on good repayment history.

Annual interest rates average between 12 and 24 percent and

can be anywhere from 1 to 60 months in length (120 months for a housing loan).

With these higher interest rates, Banco Sol does not rely on subsidies

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Illustration 1India SME Finance and development project:

The Small Industries Development Bank of India (SIDBI) served as the implementing agency because of its designation as the apex-level financial institutional responsible for SME financing and development in India. 60 percent of the total

funds allocated to the credit facility (CF) was utilized by SIDBI for on-lending to eligible commercial banks (Tier 2 FIs) to refinance (new) term lending to commercially viable SMEs, and

40 percent of funds allocated to the CF was used by SIDBI for direct financing of commercially viable SMEs. SIDBI assumed the credit and investment risk related to the loan, with final beneficiaries (SMEs) paying market rates of interest

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Illustration 2China MSE Finance Project

The objective of this project was to provide working capital and investment finance to MSEs on a commercial basis. The funds of the

credit line were channeled through the China Development Bank (CDB), the wholesaler, to participating financial institutions (PFIs).

The CDB was responsible for lending and arranging technical support for PFIs engaged in MSE lending operations.

CDB provided medium to long-term loans to PFIs with maturity up to 10 years, including a grace period up to 5 years.

The range of maturity and grace period for PFIs loans were determined at design stage,

interest rates for the same were determined based on CDB’s costs of funding and its credit rating of the PFI

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Proposed Solution Establish a Mutual Credit Guarantee Scheme aimed at pooling

and sharing risk would enable the financial market to work for local mostly smaller construction firms.

How does it work?i) Interested firms pay a sufficient contribution as a disincentive to

willful default, limiting possible moral hazard effect on borrowers. ii) Pooling of participants induces peer pressure, encouraging

compliance with contract terms and conditions iii) The public sector would provide a fund to cover default to an

agreed amount. iv) A committee consisting of participants, participating commercial

banks and the respective Construction Association will act as an oversight of the risk covering facility.

v) Guarantee pools would then operate on a given size and sequenced to ensure peer pressure, i.e. only 25-40% of outstanding guarantees will be issued to members of any one pool.

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Proposed Solution

Guarantee Fund Banks Developers

Contribution from members

Matched by GEM Project

50%

50%

Guarantees provided by the Fund to a few Participating Institutions

Development Loans provided to Members

Mutual Guarantee Fund: Set-up

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Proposed Solution

Guarantee Fund Banks Developers

Contribution from members

Matched by GEM Project

50%

50%

Development Loans provided to Members

Developer members in the Fund taking over failed projects

Option 1 – in red

First 25% of the loss borne by members contribution only

Remainder shared 50-50 between Bank and members

Option 2 – in purple

Mutual Guarantee Fund: In case of Loss

Project abandoned

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Next Steps

REDAN members agree to basic principles after wide consultations

GEM Project to field financial expert to develop detailed design operation manual and legal agreement.

REDAN finance to recruit the necessary staff to implement the mutual guarantee.

REDAN finance and GEM project sign a collaboration agreement.

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