Is Pooled Financing a Magic Bullet?

Today, many developing countries need infrastructure financing to accommodate massive influxes of rural populations to metropolitan areas. Between 2010 and 2030, there will be demand for $15.8 trillion in infrastructure in Asia, $1.3 trillion in emerging Europe, and $1.2 trillion in Latin America. Typical infrastructure investment is the responsibility of subnational governments (SNGs) such as states, provinces, and municipalities. Access to capital markets is essential for these institutions, but borrowing can be difficult for smaller governments. SNGs face multiple challenges in obtaining financing, including lack of financial expertise, limited access to financial markets, bond markets biased toward larger issuances, and, most importantly, the high cost of issuing bonds and obtaining financial ratings.

In a recent study published by the World Bank, Lili Liu, Michael De Angelis, and Sally Torbert explore a potential solution for local governments to better utilize capital markets. They examine the structures and mechanisms that make pooled financing successful in the United States, focusing primarily on municipal bond banks (MBBs). These banks are designed to lower transaction costs for municipal borrowers by packaging small municipal issuances into one larger “pool” issuance. These pools often have better ratings and liquidity than local governments could achieve alone, making them more attractive to buyers. Moreover, MBBs provide technical assistance to governments in the debt issuance process and during the loan term. Financial pooling has successfully aided small American municipalities in accessing private capital. With proper mechanisms and regulations, the researchers believe the concept can be similarly employed in developing countries.

Liu, De Angelis, and Torbert evaluated New Hampshire Bond Banks and Maine Bond Banks, two MBBs in the U.S., focusing on their legal status, managerial systems, financial sustainability, pooling mechanisms, oversight, and default remedies. Researchers sought to determine ideal conditions for successful financial pooling via MBBs. They drew on the historical experience in the U.S. to identify important factors that developing countries could replicate.

First, researchers determined that the success of pooled financing in MBBs in the U.S. rested on a well-developed legal framework. Conflicting laws governing pooled financing could potentially leave bondholders vulnerable to both political interference and uncertainty driven by inexperienced judiciaries. Confusion about how to seek legal protection can discourage potential bondholders. A comprehensive legal framework with clearly defined rights and obligations for borrowers and lenders, audit requirements and relevant disclosures can boost confidence in these markets.

Researchers observed that the New England banks placed priority on creditworthiness over other considerations. Though MBBs can help lower barriers to financing in developing countries, they cannot compensate for borrowers’ weak credit. It is essential to ensure that pooled financing agencies maintain standards for creditworthiness of borrowers, and are not influenced by crony capitalism (e.g., supporting local governments with strong political ties to the central government). With the proper fail-safes in place, these agencies can withstand political pressure to lend to SNGs or infrastructure projects that do not meet their requirements.

Finally, the U.S. MBBs benefited from high standards of financial management and financial reporting at the SNG level. Private investors typically require detailed reporting from their investees about current financial conditions. Unfortunately, it is uncommon for local governments in developing countries to produce this level of reporting, especially for external parties. Reformed financial management to provide uniform standards of financial reporting and accounting would address a number of these issues.

As countries around the world continue to experience population shifts requiring additional infrastructure funding, SNGs must decide whether they are willing to support sound regulatory frameworks and make significant financial reforms. For those who decide to do so, pooled financing could be an effective tool for borrowing money at a relatively low cost.

Article source: Liu, Lili, Michael De Angelis, and Sally Torbert, “Municipal Pooled Financing of Infrastructure in the United States” World Bank Policy Research, Working Papers, No.8212 (2017).

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