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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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Governments also often commonly provide catastrophe insurance (or reinsurance)—hedging instruments against natural disasters, crop failures, and terrorism. Catastrophic events are rare but carry very large losses. The statistical uncertainty about the risk prevents market participants from estimating adequate premiums, while potential losses can be so high that markets can be unable to refinance insurers in severe circumstances.

Many governments are traditionally involved in the provision of social insurance, including health insurance and pensions. Also, governments and central banks commonly provide special services to the financial sector, e.g., they invest in financial infrastructure, such as the payments system, and offer crisis resolution and emergency liquidity assistance mechanisms, including deposit insurance and last-resort lending.

Lastly, many governments in developing countries sponsor poverty-related microfinance programs. Microfinance is different from other public financial access interventions in its long-term emphasis on empowering the clientele. Very poor individuals may have a demand for small-scale savings, credit, insurance, and remittance instruments. Providing them with financial access is socially desirable, but often unprofitable due to high transaction and agency costs. It is hoped that beyond immediate social support and poverty alleviation, the longer-term effect of microfinance should be the inclusion of recipients in the mainstream economic and financial system. While there are positive examples of self-sustaining private microfinance operations, a substantial government subsidization or organizational involvement is still most commonly required. Similar issues exist for access to finance in geographically remote or insecure areas. An additional rationale for providing access is the need to foster integration between those areas and the rest of the country.

1 It may be costly or impossible for private agents to enforce rights against counterparties in foreign jurisdictions, while the government may have more channels for commercial conflict resolution with other sovereigns.

16

III. ORGANIZATION OF PUBLIC FINANCIAL INSTITUTIONS IN DEVELOPED COUNTRIES

–  –  –

We distinguish six distinct financial instruments that are provided by the sample of public financial institutions (see Table 2, column 1).

• Direct lending to ultimate borrowers.

• Intermediated lending – providing credit to private lenders (e.g., commercial banks), earmarked for further intermediation to the designated sectors or firms.

• Public securitization—purchasing existing loan portfolios of private lenders.

• Guaranteed market securitization – guaranteeing private lenders’ loan-backed or mortgage-backed securities (LBS, MBS).

• Credit guarantees on private loans to, and securities issuance by, ultimate borrowers.

• Market liquidity provision – public portfolio investments aimed at increasing the financial market’s depth.

Any provision of public credit typically involves a degree of subsidization along price (interest rate) or nonprice dimensions of the lending contract. This is natural, because nonsubsidized credit can equally be provided by the markets. The rest of this subsection addresses some trade-offs in the choice between different financial instruments provided by public financial institutions.

Direct versus intermediated financing

Intermediated public finance outsources to the private sector borrower screening, monitoring and retail relationship management functions—areas where public institutions may be relatively inefficient. Ideally, by engaging the private lenders, intermediated financing can also contribute to the development of financial markets.

Public financial institutions that provide direct lending may operate as first-tier banks, providing services through retail chains. We find a number of such institutions in our sample (Canada, Japan). There can be two possible rationales for the direct provision of credit. One can be the need for universal coverage, such as in agriculture finance. Another can derive from synergies with nonlending operations, such as consulting services extended by public financial institutions to small businesses or agricultural producers. It remains unclear, however, even with these economic reasons in place, whether it may be more efficient to procure retail network and consulting services from the private sector.

17 There may be another reason for direct lending, but applicable more to developing countries.

Intermediated finance creates an additional layer of agency costs in public lending; therefore, its efficiency critically depends on the government’s ability to contract with private lenders.

In many developing countries, public procurement is not well developed and may be associated with even higher inefficiencies than direct public provision of services.

Improperly designed public lending or guarantees may lead to soft budget constraints and the deterioration of private screening and monitoring incentives. Nontransparent contracting between government and commercial banks may breed corruption. Private lenders may become engaged in rent seeking (e.g., by lobbying for program expansion) rather than concentrating on the prudence of lending.





There are a number of mechanisms that can be used to alleviate agency problems in intermediated public finance.

• Caps on lending or guarantees extended to a given private lender in a given period can induce the lender to be more selective in choosing borrowers. They can also restrict incentives for rent seeking by lobbying for program expansion.

• Periodic reviews of credit quality, with a system of performance-based bonuses and sanctions.

• Substituting lending with “smart subsidies,” in the form of ex-post grants to ultimate borrowers who have successfully repaid private lenders on commercial terms. Such interest rate subsidization bypasses banks and, hence, may be less distortionary to their screening and monitoring activities. On the other hand, smart subsidies can lead to over-borrowing and be organizationally challenging to implement.

The optimal solution to the direct versus intermediated public finance trade-off depends on the relative size of public and private sector agency problems. However, since governments are intrinsically likely to be over-intrusive, it is advisable to see intermediated lending as a default approach of the two, unless a clear case can be made otherwise.

Lending versus guarantees

Another trade-off is between public lending (direct, intermediated, or public securitization) and guarantees (credit guarantees or market securitization). Guarantees can engage private lenders more deeply, and, therefore, be beneficial for financial market development. Limited guarantees may help preserve private screening and monitoring incentives.

Guarantees do not require public resources at the time of underwriting, and afterwards rely on them also only in a limited set of contingencies. On the surface, this may be fiscally 18 prudent, as the initial use of public resources is minimized. However, the fact that guarantees do not require public money upfront may create the conditions for laxity in financial discipline in guarantee underwriting. Unless strict controls are in place, there is a danger of extending too many guarantees too easily, without proper risk assessment or preparation of contingency plans for the coverage of future losses. Our review of annual reports and other documents of public financial institutions reflected the scarcity of information on risk assessments for guarantees. This suggests that this dimension may not be receiving the necessary attention and could pose unaccounted fiscal and potential financial stability risks.

Accountability issues are likely to be of critical importance in public guarantee programs in developing counties.

Recent trends in public financing

Often, SMEs have good access to senior debt, but suffer from the inability to raise junior debt or equity. Mezzanine financing (debt convertible into equity in the case of the company’s underperformance) is often used in private venture capital, and is regarded as an instrument most suitable for alleviating moral hazard problems in entrepreneurial finance. In the last decade, some public financial institutions in our sample, such as the Business Development Bank of Canada (BDBC) and KfW Foerderbank, have acknowledged these financing needs, and started providing SMEs with more sophisticated financial instruments. Regional Venture Capital Funds in the U.K. makes equity investments in private regional investment companies, supporting their equity investments in local businesses.

When financial market performance is compromised by insufficient depth, the government may intervene to enhance market liquidity. Additional depth contributes to market activity, reduces risks and costs of trading, creates conditions for more informative prices, and stimulates investment in infrastructure and specialized expertise. High Technology Fund in the U.K., and the analogous programs within the BDBC and KfW Foerderbank, invest public money in venture capital markets through privately run commercial fund-of-funds. Such an arrangement allows the outsourcing of investment picking to the private sector. Public investment funds are open to private co-financing on market terms.

While public investment companies and venture capital funds represent a possibly efficient and not distortionary mechanism of public intervention, it should be kept in mind that equity and especially venture capital investments are risky. The venture capital program of the BDBC made losses in five out of seven years of operations (maximum loss was 20 percent of investment in 2002/03). While such performance may be a part of a normal returns pattern for venture capital investments (in fact, BDBC is reported to have done as well or better than the Canadian VC market on average over that time frame), this may lead to budgetary controversies in public institutions.

19

Directed lending

Another mechanism, often used by governments for stimulating the financial access of sectors, but not covered in this study, is directed lending, where banks are obliged to devote a share of lending to defined preferential borrowers. Such restriction on activities represents an implicit tax, but with uncertain and hard-to-measure monetary value. The potential hazard of ill-designed directed lending programs is that they can compromise the soundness of financial intermediaries. The U.S. Community Reinvestment Act is an established example of a directed lending program.

–  –  –

Typical arrangements Most surveyed public financial institutions finance their lending operations by borrowing from financial markets (Table 2, column 3). While there may or may not be explicit government guarantees on the public financial institutions’ debt, markets always perceive an implicit guarantee (Table 2, column 4). Most public lenders are formally intended to break even, but have an implicit subsidy in the form of preferential market access (courtesy of government guarantees—Table 2, column 6), and, occasionally, tax breaks and simplified regulation (Table 2, columns 10–11).

Japan had a special mechanism (currently under reform) of public lender’s borrowing—the Fiscal Investments and Loan Fund. The Fund issues government-guaranteed bonds (mostly acquired by Japan Post), and makes proceeds available to public lenders at market rates that are benchmarked by policy-adjusted rates.

Subsidization and government guarantees

The implicit subsidy stemming from guarantees should not necessarily be regarded as a sign of inefficiency. The lower profitability of public financial institutions is explained by the fact that they fulfill social (policy) goals and lend to less creditworthy or profitable borrowers, who are not well financed by the market. Therefore, a degree of subsidization may be a natural outcome.

The U.S. case exemplifies that financial markets always perceive government guarantees despite possible official statements to the contrary. It stems from the institution’s systemic and policy importance and general close affiliation with the government. Market exposures to public financial institutions stemming from perceived guarantees may indeed render government intervention ex-post necessary in the case of financial trouble.

The main concern here is the accountability of government guarantees on public financial institutions’ debt. It seems prudent to accurately estimate government exposures and 20 establish fiscal contingency plans. This is particularly important, since many types of public financial services, such as housing or agriculture finance, are associated with large, undiversified exposures. The assessments of the value of received guarantees and of possible government fiscal risks were commonly lacking in the public accounts of institutions in our sample.2 From the standpoint of accountability, it may be advisable to adopt explicit guarantees as a default solution.

Credit guarantee programs

Credit guarantee programs typically target the smallest firms which lack bankable collateral, making them high-risk borrowers. As a result, credit guarantee programs are commonly loss-making and therefore explicitly subsidized by the government. The specter of possible losses observed varies from 2.6 percent of lending in Canada to 35 percent of loans that default in the U.K. The losses should not necessarily be seen as a sign of inefficiency, rather they can reflect a proper focus on the smallest new firms (see Graham Review, 2004).

–  –  –

Our sample provides examples of a wide range of public financial institutions’ ownership structures (Table 2, column 7).

• Wholly government-owned, nonprofit corporations – the most common ownership structure.

• Programs within the departments of the executive – typically smaller scale with a narrow focus, such as credit guarantees

The United States has adopted an approach (in some cases) of privately-owned, publiclychartered financial services:

• Private for-profit corporations—Fannie Mae and Freddie Mac.



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