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TOWARDS A FRAMEWORK FOR INVOLVING

FINANCIAL INTERMEDIARIES IN MUNICIPAL


FINANCE PROJECTS

Kamran Khan
East Asia and Pacific Region
Infrastructure Department
Urban Sector Unit

Municipal Infrastructure Development and the


Financial Intermediary (FI) Model

1. Financial market development lags behind the demand for long-


term financing for municipal infrastructure development
2. Increasing pressure to provide municipal infrastructure
3. The promise of a specialized institution that can channel public
and/or private capital into municipal infrastructure development
4. Availability of an external source of long-term capital (ODA)
ƒ National and/or sub-national government budgets (decentralization)
ƒ The donors’ interest in the wholesaling approach

Numerous variations of FI models involving municipal


infrastructure have been implemented around the world
– FI programs are designed to meet the time-specific needs of a country
– Provision of technical assistance is an important part of FI programs
– Sound regulations / strategic planning are often the key to success

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Key Risks Associated with FI Models

• Policy Capture: Risk that the government may use


the FI for political objectives, e.g. directed credit of
subsidized loans which undermine financial viability
• Private Sector Crowding-Out: FIs often receive low-
cost capital and free technical assistance, and can
stop the private sector from entering the market
• Mismanagement: Over-capitalization and lack of
transparency can lead to mismanagement of funds
• Contingent Liability / Fiscal Risk: The implied
government guarantee of FIs’ market borrowings may
give rise to the “moral hazard” problem

Global Experiences with FI Models

Summary of Common Financial Intermediary (FI) Models for Municipal Infrastructure


Institution and Business Key Applicability
Country Model Features Considerations
Infrastructure Finance INCA makes sub-national loans, • Buy-back facility provides • Broad-based financial market with plenty of
Corporation of SA and buys-back similar debt from liquidity to the private market private banks lending to credit worthy sub-
(INCA), South Africa private lenders; extends • Extension of maturities nationals
maturity of refinanced debt increases affordability • Lack of long-term capital (market depth)
• Lack of liquidity a key bottleneck
Tamil Nadu Urban State (provincial) debt fund • Provision of specialized • State government credibility established to
Development Fund provides financing and financial assistance to public agencies in encourage private investment in the fund - not
(TNUDF), India structuring advice to public preparing projects replicated to date in other Indian states
entities; pools bonds for small • Private partners play a key role • Municipal bond benchmarks in place
issuers in fund management • Established private rating agency exists
Buy-back facility offers • Avoids project or borrower risk – • Banks interested in and comfortable with sub-
discounted take-out financing investments are backed by the nationals / project SPVs as borrowers
FINDETER, Columbia for private lenders who make Balance Sheet of participating • Lack of liquidity in the market
loans to sub-nationals / project banks
SPVs • Plenty of participating banks with sound financial
position / institutional capacity

Municipal Finance Long-term funds borrowing • No loan origination or • Establish market (appraisal standards,
Company (MUFIS), window for private lenders underwriting functions benchmarks, etc.) for top tier borrowers
Czech Republic making loans to sub-nationals • Focus on middle / low tier •Lack of long-term capital (market depth)
and project SPVs borrowers • Plenty of participating banks with sound financial
position / institutional capacity
Local Government Unit Bond guarantee fund which • Proprietary bond rating system • Institutional/market incentives in place to
Guarantee Corp guarantees bonds issued by the to price risk encourage sub-nationals to issue bonds
(LGUGC), Philippines local governments • Homogenization of credit quality • Municipal bond benchmarks in place
of sub-national debt • Market depth and willingness for LGU risk

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Framework for Pursuing the FI Approach
Framework for Pursuing the Financial Intermediary (FI) Approach
Focus Primary Criteria Possible Key Considerations
• Possible considerations for pursuing a FI strategy:
– There is a lack of long-term capital in the market
Is the FI necessary to achieve – Private market is not ready to directly finance program objectives
program objectives?
– Public sector co-financing is necessary to attract private capital

Financial – Credit enhancement is necessary to finance infrastructure projects


Market – Lack of capacity to produce financially viable projects
– Need for a specialized public institution to negotiate with private sector (PPI contracting,
etc.) and attracting private capital

• How serious is the risk of private sector crowding-out in the short, medium and long-term?
Will the FI support or distort • Is there a clearly defined long-term role for the FI?
market development?
– Will the FI compete with or support market players in the future?
• Will the FI function support market development (new instrument, improved appraisal
standards, sec. market activity, etc.)?
• Is the involvement of FI likely to support policy reforms, including:
Can the FI structure contribute – Tariff rate increase to support sustainable financing of infrastructure
Sector Policies to sector policy reform? – Support to public utilities vis-à-vis structuring of financing plans
– Strategic planning for investments, and transparency of operations
– Commercialization of SOEs and other public utilities

• Institutional structure in place to minimize the “policy capture” risk


Under what conditions should –corporate governance (Board appointments, management and independence and
Partnership the government & donors established investment policy)
Conditions support the FI? • Appropriate financial risk management structure is in place
–-market pricing, cost-recovery, portfolio monitoring/management
• Institutional capacity to manage social/environmental safeguards
• Co-financing/syndication with private sector; long-term transition towards private sector role
Support to the FIs should in financing and management of FI
Partnership support what types of business • Safeguard against over-capitalization - capitalization tied to FI’s portfolio risk, market
Strategy models? demand and absorption capacity
• Transition towards commercialization / corporate independence

Development Path for FIs in Municipal Finance

¾ Corporate ¾ Investment Capital: ¾ Investment Capital:


Governance: • Injection of private
• Demonstration of
• Corporatization sound financial and equity
(from government corporate • Increase in senior
operations) management debt
practices
• Transparency ¾ Private Sector
• Senior debt through Participation in
• Reform of PPP market transaction Management
rules
¾ Standard Setting: ¾ Long-term Role:
¾ Investment Policy:
• Increased • Transition away
• Eligibility Criteria syndication from primary market
• Risk Management • Establishment of towards narrow
¾ Investment Capital: standards in market function
• Borrowing partnership with • Support to market
structure public/private players on setting
• Government / partners benchmarks
ODA assistance ¾ Investment Track- • Maturity extension
Record • Securitization

Short-term Medium-term Long-term