Guidelines on Local Government Borrowing and Recent Developments in South East Europe
6. How to find and select the lender?

6.1. Financial institutions specialized in lending to local governments
6.1.1. Lending institutions, the rules they are operating with, markets they are thriving in and markets they avoid

The development of local government credit markets represents an important pillar for the expansion of local public goods and services (both quantitatively and qualitatively). In Chapter 3 we identified two models that underpinned the development of local credit markets: (i) bank lending model and (ii) municipal bond model

In the bank lending model, financial institutions that lend to local governments can be largely divided into those specialized in 'niche' banking, targeting only local business (municipal banks) and those involved in a large spectrum of banking activities – retail, corporate, investment banking.

The main differences between municipal banks and large commercial banks that lend also to other sectors consist in (i) the types of available lending products and characteristics (pricing, maturity etc), (ii) the way they build their relationship with local governments, (iii) the range of support services they provide to local governments besides the lending activity or (iv) the monitoring and analysis capacity. One characteristic of municipal banks is their ability to provide longer-term lending to local governments as compared to other commercial banks, as they are most of the time state-owned and thus have access to long-term resources. For example, Credit Locale de France used to have access to long term funds accumulated through the postal system's savings plan for small savers. Municipal banks aim at developing a permanent relationship with local governments, whereby, besides the lending activity, they also provide a range of complementary support services, such as advising on the preparation and structuring of budgets or designing of investment projects.

Initially municipal banks' special status was protected by law; they effectively enjoyed legal monopoly (e.g. Municipal Bank of Netherlands). However, financial sector deregulation put under pressure municipal banks, as it opened the ground for competition on local government segment from other financial institutions (commercial banks). Today, most of the municipal banks lost the preferential access to long term resources and had to enter competition with other banks for (short-term) funds. Dexia, is one example of large municipal bank which survived this process. Formerly government owned, Dexia is now fully privatized and competes throughout European market with other commercial banks as an alternative supplier of capital for local governments. The state owned National Economy Bank from Poland is another example of specialty municipal bank. It specializes in assisting to the public sector through provision of support to the state's social and economic programs and local governments regional development programs.

In developing countries where municipal banks have little or no history, the process of financial deregulation brought municipal lending under the umbrella of standard commercial banking. The short term savings horizon which is characteristic for commercial banks translated into loans to local governments with shorter maturities as compared to those offered by specialty municipal banks. Also, as lending to local governments for a commercial bank represents only a fraction of its portfolio, the resources allocated to acquire and build expertise on local finance mechanics are scarce. This results in a more narrow range of lending products and higher borrowing costs. OTP Bank in Hungary or Erste Bank's Banca Comerciala Romana are two examples of large commercial banks that dominate the local governments' credit market, in the absence of municipal banks17.

A special category of lenders to local governments are the international financial institutions (IFI) – e.g. World Bank, European Bank for Reconstruction and Development, European Investment Bank, European Council Development Bank – which are running dedicated programs aimed at supporting and financing local governments' infrastructure projects, especially in the emerging markets (see Chapter 3).

The municipal bond model, as an alternative/ complementary way to develop local government credit markets differs from the bank lending model in the following aspects:

it is based on competition and not relationship banking,

monitoring is public and not proprietary, and

support services are unbundled.

Competition is the essence of local capital financing; neither institutional nor individual bond investors need to have a long term relationship with the issuer as it happens in the bank lending model. Whereas in case of bank lending model, the monitoring and analysis of local government financial position is done by the lending bank, in case of the municipal bond model, the financial information is disclosed by the issuer to the market in a standardized format; based on this information, each investor makes its own assessment of the opportunity to invest in a particular municipal bond issue. Furthermore, in a municipal bond market a local government can make its own decision on where to seek financial advisory services or technical assistance on project design as compared to the bank lending model where such services may be bundled.

Emerging markets are an attractive target for foreign financial institutions as they can offer superior risk adjusted returns. Low development of infrastructure (of all kinds) along with the perspective of a stable and predictive macroeconomic environment and coupled with credible economic policies are key ingredients for a developing economy to attract foreign financing. Moreover the status of member to international organizations (such as EU, NATO, WTO), which underscores a country's commitment to adhere to certain sustainable development landmarks, brings additional guarantees to foreign investors. Geographical and geopolitical position of a country also matters.

In this context, lending to local governments in eligible emerging markets may represent a viable and productive business opportunity for foreign financial institutions. Creditworthiness is usually better than that of private sector borrowers given their permanent revenue generation capacity, but below sovereign creditworthiness, thus ensuring attractive returns at relatively lower risk. During the current financial and economic crisis, some banks from emerging countries found it more profitable to finance local governments rather than the private sector, as the latter's debt servicing capacity had been severely impaired by the economic downturn. One such example is Banca Comerciala Romana, the market leader in the Romanian banking sector in terms of total assets, which managed in 2009 to partially compensate for the deleveraging that occurred in its portfolio of private debtors by expanding into the local governments segment. The willingness and capacity of financial institutions to finance local governments varies across target emerging countries due to a number of specific factors which characterize the degree of development of local public finances in general, such as (i) transparency, (ii) access to financial data, (iii) administrative capacity, (iv) revenue stability and predictability, (v) regulation of local public debt, (vi) existence of bankruptcy procedures or (vii)

Table 5: Type of allowed guarantees and collaterals:

of bank
commercial bank
State owned commercial bank Statebank Donor-
International financial institutions Other
Albania National Commercial
Bank, Intesa
Bank, Raiffeisen
  Albanian Development
Fund, Highland
  KFW, World
Bulgaria Municipal Bank plc       EBRD, EIB  
Croatia   Croatian Bank
for Reconstruction
and Development
  United States
Agency for
Kosovo Pro Credit
Bank, Raiffeisen
Bank,NLB Prishtina,
Banka Kombetare
Tregtare (National
Trade Bank)
Macedonia Macedonia: Credit enhancements (guarantees by USAID through Development Credit Authority)     USAID DCA
Moldova Victoriabank, Eximbanc,
Savings Bank
(Banca De
Fund of Social
Montenegro Crnogorska komercijalna
banka, NLB
Hypo Alpe-Adria
Bank, Podgoricka
banka, Komercijalna
banka AD
Fund of
Hypo Alpe Adria,
Unicredit, Raiffheisen,
of Republika
Incentive funds
agriculture and
economy development
Romania Banca Comerciala
Romana S.A.,
Bancpost S.A., BRD
– Groupe Société
Générale S.A.
      EBRD, EIB,
Serbia Intesa Sanpaolo,
Unicredit, Hypo
Alpe Adria, Commercial
bank, AIK
bank, Raiffeisenbank,
Erste bank,
NLB Vojvodjanska
bank, Credit, Agricole
  State Development
WB, Council
Turkey BNP Paribas Fortis,
WestLB AG, Credit
Agricole, HSBC,

6.1.2. Market failures and possible solutions

Both the bank lending and the bond model bear drawbacks that may limit the development of functional credit markets and lead to inefficiencies. As outlined earlier, commercial banks usually lack the capacity to understand local public finances and consequently the propensity to lend to local governments may be lower. Also, due to the fact that they attract resources on the short term, their ability to lend on longer terms is impaired. In case of bond issues, the lack of adequate financial disclosure may deter investors frompurchasing municipal bonds. Moreover, past experience shows that in its early stages, local government bond markets do not necessarily provide longer-term capital than compared to bank lending.

In this context, there are several options available to central governments from emerging economies that can enhance the development of sustainable local credit markets:

a) General

Promote economic policies that lay the grounds for a stable and predictive macroeconomic environment (e.g. anti-cyclical monetary and fiscal policy);

Ensure the development of a sound and financially stable banking sector; prevent through adequate regulation the build-up of large imbalances in banks' portfolios (e.g. excessive lending towards specific sectors, large share of foreign currency loans), that could impair banks' future lending capacity;

Increase transparency of local governments (e.g. standardized disclosure formats on financial position, investment projects, audited financials);

Promote and support the establishment of an authorized local credit rating agency specialized on local governments' credit risk assessment;

Increase the incentives for local governments to have credit rating from a rating agency (local or international) – e.g. increasing risk weight for unrated local governments and variable risk-weight for rated ones in calculation of regulatory capital for banks à this would result in higher borrowing costs for unrated local governments; And

Define clear legislation and procedures for local government bankruptcy – remove implicit central government guarantee of local debt.

b) Specific

The existence of municipal guarantee funds can stimulate the development of local government credit markets in its early stages. However, it is important to use such an institution only for a limited period of time, as it can result in moral hazard behavior (see examples below);

The establishment of state-owned banks specialized in municipal lending can enhance the access of local governments to credit markets. Such banks can usually tap longer term resources, which can be channeled into local government long-term infrastructure projects.

Municipal development funds established and operated at a level above that of individual local governments represent also a potential solution to enhance local credit markets and support the investment in urban infrastructure, services and enterprise (see examples below.)

Enhancement mechanisms that support the development of LG credit markets
a. Guarantee funds

Bulgaria - the USAID Guarantee Mechanism - Development Credit Authority (DCA) provides guarantees for municipalities as borrowers to United Bulgarian Bank guaranteeing 50% of the loans. 13 municipalities have used this instrument so far.

Macedonia – similar mechanism to Bulgaria

Romania – there are two guarantee funds (Rural Credit Guarantee Fund and Small and Medium Enterprise Guarantee Fund) which provide letters of guarantee and loan guarantees in the name of local government beneficiaries of EU-grants.

6.1.3. The situation in the target countries

Past experience has shown that lack of discipline of decentralized local governments related to local public indebtedness may cause financial distress at macroeconomic level. In the past 20-30 years the state budgets had to intervene and bail out local governments in 19 out of the 44 countries analyzed in a 2005 study by Singh and Plekhanov18. For example, in Argentina and Brazil local government difficulties caused a serious burden for the national budget contributing to the emergence of financial crises.

In case of EU member states, indebtedness of local governments has not raised worries so far; however periods of financial distress can be traced back in the recent history (Germany and Sweden in the 1990s).

Such a situation clearly calls for some controlling mechanisms aimed at ensuring financial stability of local governments. The literature identifies four regulation mechanisms of local public indebtedness (Ter-Minassian-Craig, 199719):

Market discipline – in this regime there is no restriction regarding local government indebtedness; financial institutions will lend based on their own risk appetite and limits. Free markets regimes are usually characteristic for developed markets;

Direct controls – lending is subject to approval by the central government. Such a mechanism clearly impedes on local government autonomy, however it may compensate the lack of discipline and administrative capacity at local level;

Rule-based approach – limits on indebtedness level are set out in legislation on local debt, either as a cap on total outstanding debt or on maximum debt service;

Co-operative approach – local governments decide together with central government on maximum debt levels.

Figure 6: Controlling mechanisms across CEE countries
LG from emerging markets exhibit usually at least one form of controlling mechanisms through direct controls and/or legal rules

* Based on Ter-Minassian-Craig, 1997

** Based on questionaire data