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«Public Financial Institutions in Developed Countries—Organization and Oversight Lev Ratnovski and Aditya Narain WP/07/227 © 2006 International ...»

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E. Study Scope and Method

This paper seeks to contribute to the analysis of public financial institutions by drawing on the evidence from developed countries. We study a sample of 18 public financial institutions from five G10 countries—Canada, Germany, Japan, United Kingdom, and United States. We focus on public interventions facilitating finance in three most commonly targeted sectors— 8 housing, SMEs and innovative firms, and agriculture. The public financial institutions included in our sample are shown in Table 1.

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We examine evidence on three dimensions of public financial interventions: Rationale, Organization, and Oversight. Within rationale, we study whether the declared or understood rationale is valid, and whether the intervention is outdated, excessive, or otherwise wrongly designed or implemented. Among the organizational features, we address the financial instruments that are provided, financing mechanisms, profitability, and ownership. In oversight, we examine how government exercises its control rights— through the mechanisms of governance structures (typically CEO and board appointments) and external regulation and supervision—and draw conclusions in respect of the best practices of public financial institutions’ governance and regulation.

Our reading of the findings is twofold:

Firstly, we find that public financial institutions even in developed countries may have an unclear or outdated economic rationale, be entrenched and inefficient, distort rather than complement markets, and be a potential source of significant systemic and fiscal risks. The extent of the inefficiencies in the developed countries is a strong caution for the developing 9 world, where government accountability mechanisms and the institutional environment may be less developed.

Secondly, we identify dominant trends in the organization and regulation of government financial services, which may provide a useful reference point. However, these practices may not be suitable for direct adoption in the developing world. Organization and regulation of financial services in developing countries may require different arrangements, particularly in those with lower regulatory capacity, lagging institutions, and less accountable and effective governments.

The rest of the paper is organized as follows: Table 2 summarizes the characteristics on key dimensions of the sample of public financial institutions. Sections II to IV address in more detail the dimensions of public financial institutions’ rationale, organization, and oversight.

Section V concludes.

Table 2. Main Properties of the Public Financial Institutions in Developed Countries (Summary Table)

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II. RATIONALE OF PUBLIC FINANCIAL INSTITUTIONS IN DEVELOPED COUNTRIES

This section is based on a review of official documents (e.g., annual reports or budgetary documentation) and official information material (from official websites) of the surveyed public financial institutions. All institutions relate the need for their presence to market incompleteness, market failures, or externalities. The rationales can be stated in more or less formal terms (be derived from formal legislation, government programs, or just policy understandings), but are largely similar in content across countries. Differences in emphasis can be traced to current or historical financial system structures or policy goals (e.g., degree of paternalistic welfare concerns).

Further, we systematically review the suggested economic rationales for public financial institutions and analyze whether such rationales indeed provide a valid justification for public intervention.

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Market incompleteness (underdevelopment) There are a number of reasons for markets’ possible underperformance in housing finance.

Individuals demand long-term and commonly fixed-rate mortgages, while banks are commonly financed primarily by demandable deposits. Banks that offer long fixed-rate

mortgages become exposed to a number of significant financial risks:

• Liquidity risk – should depositors decide to withdraw unexpectedly, a bank may be unable to repay them, as long-term mortgages are nearly impossible to liquidate; and

• Interest rate risk – should short-term interest rates rise, the costs of new deposits for the bank would increase, reducing or rendering negative the bank’s margin.

The bank’s ability to provide mortgages depends on whether it can hedge these risks.

Hedging opportunities depend on financial market development:

• Liquidity shortages can be covered by short-term bridge borrowing, which requires sufficiently deep money and bond markets; and

• Interest rate risks can be hedged by interest rate derivatives, such as swaps. This requires developed interest rate derivatives markets. Alternatively, they can be avoided by long-term, fixed-rate borrowing by banks themselves. Such long-term funds can be provided by a developed private pensions or life insurance industry.

In addition to liquidity and interest rate risks, there is mortgage credit risk. That risk can be systematic and difficult to diversify, particularly when house prices are correlated within and across geographic regions, and co-move with the business cycle. The mortgage risk management problems are further amplified by the mere volume of mortgage finance required to respond to the housing needs of a growing economy.





12 Social concerns In some countries (e.g., Canada), the need for appropriate housing is a part of the government’s welfare policy agenda. This gives rise to the policy of social housing, for which preferential financial access may be one mechanism.

B. Small- and Medium-size Enterprises/Innovation Finance Market failures in SME finance Potentially, long-term creditworthy small- and medium-size enterprises (SMEs) may have difficulty in obtaining initial credit from commercial banks. The underlying reasons are the lack of collateral or credit history, and the high transaction and agency costs of small-scale lending. As a result, long-term, creditworthy SMEs may get “trapped;” by not getting financing today, they are deprived of business opportunities, cannot accumulate collaterlizable assets or develop credit history, nor can they increase the scale of their business to become more attractive to borrowers in the future.

Market failures in innovation finance

Innovation finance, e.g. venture capital, is a sophisticated activity, which requires significant sunk investments in expertise and relies on risk sharing between a number of specialized markets. In a simplified way, the innovation finance chain can be represented as early-stage financiers selling maturing ventures to later-stage investors, who in turn exit through an IPO or a merger. Innovation investment would not take place unless specialized financiers are confident in the liquidity of their exit markets. Therefore, innovation finance requires simultaneous depth of a number of markets, which may fail to happen by itself due to low economic activity or coordination problems, thus creating a field for public intervention to foster the liquidity of innovation markets.

Externalities SMEs are universally regarded as a major source of employment in the economy. Smaller and innovative firms are also seen as keen adopters of new technologies, producing positive spillovers on the rest of the economy.

Community finance There is a distinct set of market failures in housing and SME finance that relate to deficient financial access in remote or poor regions or neighborhoods, so-called “community finance” issues. Individuals and businesses in communities with historically undersupplied finance lack not only collateral and personal credit history, but also suffer from the paucity of community-specific statistical information, making lending to them ever more risky and unattractive (in the absence of information, banks may assume the worst or just refrain from lending due to being unable to quantify the risks). As a result, whole communities can be “trapped” in low financial access triggered by unresolved community-wide statistical 13 uncertainty. Geographic remoteness from major financial centers of financially consolidated economies can be an additional problem.

Also, undersupplied community lending may be associated with “capital drain,” where communities deprived of credit still have access to savings facilities, but with received funds being invested elsewhere. As a result, the savings of capital drained communities do not contribute to the local economy. The typical solutions to the capital drain problem are public (such as Spaarkassen or Landesbanken in Germany) or directed (such as the Community Reinvestment Act in the U.S.) community reinvestment schemes.

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Market failures Agricultural production is subject to highly systemic shocks, with some of them being close to catastrophic—low crop yields or diseases. Other shocks include agricultural commodity price movements and export fluctuations. At the same time, agriculture critically depends on effective and smooth financing. Farming is a low-yield but capital-intensive industry, with long gestation periods. Credit is required to achieve efficient resource allocation: facilitate transitions in and out of business, and allow smooth intergenerational agricultural asset transfers. Due to significant risks coupled with low profitability and long gestation periods, markets may be unable to provide the desired level of credit, particularly to small/family farmers.

Externalities and rural financial access Agriculture is regarded as an important source of employment for the economy. Also, some agricultural production takes place in remote areas, creating a need for universal coverage, which markets may find hard to provide.

–  –  –

We have outlined above the possible valid economic rationales for public intervention in the provision of financial services. The described market failures are economically plausible, and, should they exist, an efficient government may address them with well-designed interventions, thereby increasing social welfare. However a deeper analysis reveals that a significant number of public financial institutions in developed countries either operate on an outdated or questionable economic rationale, or are excessive in their scope and therefore distort the markets and likely reduce social welfare.

Outdated rationale: housing finance

Public programs of housing finance provide a striking example of significant public involvement in financial markets, operating on a mostly outdated rationale. Most surveyed housing finance programs were launched in the first half of the twentieth century against the background of underdeveloped financial markets and banks financed predominantly by local 14 deposits. Government intervention was beneficial, helped create housing finance infrastructure, and gave a strong impulse to the development of private mortgage markets alongside public institutions. However, there is no doubt that today’s financial markets in developed economies can provide most services supplied by public housing finance institutions. The only area where government intervention may still be warranted is the financing or construction of social housing projects, but it is not clear whether preferential lending is the right modality of intervention there.

Public housing finance institutions were not responsive to the development of the financial markets, and failed to downsize accordingly. In addition to creating market distortions, continued government intervention poses significant fiscal and financial stability risks. In the U.S., the total volume of government-sponsored housing lending and guarantees stands at about 40 percent of GDP, and while that number is smaller in Canada, Germany, and Japan—being in the region of 7 percent to 10 percent of GDP—it is still significant. House price shocks can lead to significant losses for government housing finance institutions, whose exposures are concentrated in the single sector. Should institutions be in financial distress, government may need to bail them out to preserve financial stability. Real estate is a primary source of collateral and the deterioration of housing finance markets may lead to a profound credit crunch. However, the bail-out of such large financial institutions would be associated with substantial fiscal costs.

Excessive intervention: SME finance

Public SME finance programs are typically much smaller in scale than housing finance interventions and do not pose systemic risks. Still, public funds can be a large share of the SME finance market, and, if improperly targeted, may compete with private credit, creating inefficiencies and market distortions. It is a matter of concern that some government SME lending programs (e.g., in Canada or Japan) provide credit also to medium-sized and larger firms, which, if creditworthy, should, in principle, be able to obtain market financing. In addition to crowding out the private sector, such public intervention may be internally wasteful, with predominantly lower-quality firms rejected by private lenders applying under public programs.

–  –  –

In this subsection, we mention some other sectors which are commonly targeted by public financial institutions, but which are not covered in our sample.

Most developed countries have public education and healthcare finance programs, rationalized by positive economic externalities and social concerns. Government often facilitates financing for infrastructure and transport projects, which commonly require long-term, fixed-rate finance not easily available on the markets (see a discussion of similar 15 problems in mortgage finance), can have positive externalities, and are sometimes seen as public goods.

Most countries have public financial institutions supporting exporters, rationalized by positive externalities as well as international contracting problems.1 Export projects benefit the economy by improving the current account and helping establish a foothold in new markets. At the same time, exporters carry foreign exchange, political, and foreign contracting risks, and the government may assist them in bearing such risks.



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