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

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

Will the FI support or distort
market development?
Can the FI structure contribute
Sector Policies to sector policy reform?
• How serious is the risk of private sector crowding-out in the short, medium and long-term?
• Is there a clearly defined long-term role for the FI?
– 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:
– Tariff rate increase to support sustainable financing of infrastructure
– 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