Guidelines on Local Government Borrowing and Recent Developments in South East Europe
3. Which debt instrument is suitable?

3.1. Bank Loans

Loans represent a common source of financing capital investments of local governments. Loans are granted by commercial or saving banks.

The terms of a bank loan will vary depending upon the local governments' individual financial position, the macroeconomic environment of the local economy as well as upon the willingness and capacity of a bank to finance local governments.

Administrative procedures that are required to take out a loan are less complex and costly than in case of a bond issue. On the other hand, large outlays for an investment project are more difficult to finance through loans from a single bank or even from a consortium of banks than through a bond issue. Moreover, bonds usually have longer maturities than loans, because some of the institutional investors (insurance companies, pension funds) buying these bonds rely on longer term resources (deposits) than banks. In some instances, banks can decide to rollover (i.e. refinance) an existing loan at maturity, thereby extending its maturity. However, structuring of a long term financing by means of short term loans, which are rolled over at maturity, exposes the local government to refinancing risk – i.e. lender might refuse at any time to renew such a loan. This could result in (i) liquidity or even insolvency issues for the local government and at the same time in a (ii) partially completed project that is of no value to anyone.

The cost of a loan is made up from the interest rate and other commissions and fees that banks usually charge. Banks set the interest rates based on current market interest rates, maturity and collateral of the loan and creditworthiness of the borrower. Rates can be fixed or floating. Floating interest rates are made up from a reference interest rate (e.g. EURIBOR) plus a fixed margin, which accounts for banks' profitability and borrower specific risk.


Bank Loans


Advantages


Provides a readily available source of financing based on competing existing local banks

Applying for a bank loan is a much simpler process than issuing a municipal bond (which makes them more suitable for smaller municipalities)


Credit analysis is performed directly by the lender

An additional credit rating from an external rating agency may not be required

Loan terms and conditions are negotiable to some extent, but they are bounded by the borrower's credit quality


Disadvantages


Interest rates tend to be higher than other types of debt (depending on economic cycle, maturity, ancillary services etc.)

Higher loan to value requirements – i.e. collateral requirements are more conservative


Less suitable for large investment projects requiring long term financing



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