2016-03-04
Proposal to regulate possibilities for banks to require warranty from natural persons for loans
Having considered both the common practice of commercial banks and other credit institutions to require that a business loan is warranted by the owners of the business it is extended to or other natural persons, and the risk posed by such a practice, the Bank of Lithuania has prepared and is submitting for a public debate its proposals on how to improve the regulation of such personal guarantee measures.
‘Since the crisis period, the requirement for natural persons to guarantee business loans has been widely applied by commercial banks and credit unions as a safeguard of their own interests, which, in many cases, is disproportional and unjustified. Guarantee is as often as not required without considering the risk for the guarantor, their earnings and assets, thereby providing conditions for natural persons to irresponsibly assume excess liabilities, which promotes personal bankruptcy as well as poses other risks,’ says Vytautas Valvonis, Director of the Supervision Service of the Bank of Lithuania.
Guaranty for a business loan means that, when a business faces difficulties in repaying a loan, the loan must be repaid by the person who had guaranteed it. The Bank of Lithuania has evaluated the data on loans extended to credit institutions and identified that the share of loans warranted by a natural person had increased in particular right before the crisis: at that time, loan extension by banks was especially intensive and, with the lack of real assets for pledge, banks started actively requiring personal warranty. In 2007–2008, the share of loans warranted expanded by more than four times, while, in recent years, every third business loan extended was under personal warranty.
Additional collateral is particularly often required by credit institutions from small- and medium-sized businesses. For example, according to the data of a business survey conducted in 2015, nearly every second (45.3%) small-sized business (up to 10 employees) with financial liabilities reported that loans extended to it had to be additionally warranted by natural persons. Warranty by natural persons was applied by 75 per cent of sole proprietorships and 30.4 per cent of public limited liability and private limited liability companies with financial liabilities. Moreover, as many as 76.3 per cent of businesses reported that the requirement of credit institutions to provide warranty was the prime condition for the provision of the loan. The requirement of credit institutions for a shareholder to warrant a loan disproportionate to their assets and revenues blurs the line between legal persons with limited civil liability (public limited liability companies and private limited liability companies) and unlimited civil liability (sole proprietorships, partnerships). The Bank of Lithuania holds the view that personal warranty may be one of the reasons behind withholding the management and shareholders of a business from timely initiation of bankruptcy proceedings, which has negative implications for all creditors of the business.
In addition, banks, when requiring guarantee, often do not consider the financial risk assumed by a natural person. In some cases guarantee is provided even without holding sufficient personal assets or the liabilities assumed by the warrantor are well above the assets held or revenue being earned. Therefore, such warranty is not economically reasonable.
The influence of guarantee is also revealed by bankruptcies of natural persons. Where businesses, whose obligations were guaranteed by the assets of natural persons, went bankrupt, their debts were collected from their guarantors, which fuelled bankruptcies of natural persons. In 2013, when natural persons first had the opportunity to go bankrupt, every fourth personal bankruptcy was related to guarantee for business loans. Having taken into account the results of the conducted survey and the risk arising from personal guarantee, the Bank of Lithuania has prepared and is submitting for public debate the proposal to improve the provisions for the regulation of guarantee and other collateral securities. It is proposed to:
1) ensure that banks are not able to require guarantee from natural persons for a loan amount that exceeds the value of that person’s unencumbered assets, i.e. natural persons would only grant loans in an amount adequate to their financial capability;
2) where a borrower is unable to repay a loan, to provide the possibility for the guarantor to make payments for the borrower from income received rather than repay all credit from their assets at once. Credit institutions and natural persons could only agree on such method of credit repayment in cases when credit is extended to a natural person.
Implementation of the Bank of Lithuania’s proposal would mitigate the risk for natural persons to assume liabilities above their financial capabilities which may lead to personal bankruptcy; the reason for owners or management of businesses to stall the initiation of bankruptcy due to personal warranty would disappear.