Municipal sector review
Iller Bank – Considerations for a reform
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Iller Bank – Considerations for a reformIller Bank has a wealth of expertise and skills which have been developed over seven decades and which could provide a solid basis and potential for the strengthening of its role in the financing of municipal infrastructure. Municipal Development In any scenario in which Iller Bank would not merely be a channel for central government transfers to municipalities, its ability to carry out its financing activities in a sustainable manner would be contingent upon the financial situation of the borrowing municipalities and in particular their capacity to service debt and allow the replenishment of Iller Bank resources. This is particularly relevant as Iller Bank’s client base is restricted to municipalities and is not likely, any time soon, to be broadened and diversified beyond such clients. The capacity of municipalities to mobilize resources requires an adequate framework for municipal revenue generation, and predictability in tax and revenue transfers from central government. Municipal development is contingent upon efficient mechanisms and institutions for revenue mobilization and transfer. Other countries have explored a range of options including:
Presently in Turkey, as in many emerging economies, it would be a challenge for most small and medium municipalities to have direct access to credit through the bond markets, even where these exist. In light of this impediment, a number of countries have established municipal development institutions as a channel for municipal credit. Some of these institutions have been administered pools of funds from government sources; others have sought, and some managed, to serve as a bridge in raising funds on credit markets for on-lending to local governments. Iller Bank’s Role in the Institutional Development of the Municipal Sector In Turkey, Iller Bank, with its strong in-house technical capabilities and decades-long presence, has been a main channel for central resource transfer to municipalities helping them improve the provision of public services. There is currently a debate among policy makers as to the role Iller Bank could play in the institutional development of the municipal sector, not only in adding to the capacity of municipal infrastructure, but also in strengthening the institutional and administrative capacity, and hence creditworthiness of local governments so as to allow them to access private sources of funding. The government may want to assess, amongst the options being considered, the possibility of building the mandate of Iller Bank beyond that of a mere conduit for budgetary transfers to local governments (as well as a valuable resource for technical assistance to municipalities). This would be particularly timely in Turkey as tight fiscal policies are restricting budgetary transfers from central to local governments even though demand for local infrastructure is growing. Private credit would therefore be required increasingly to meet the funding gaps and allow municipalities to finance their infrastructure investments. In this case, the main challenge for the government would be to strengthen Iller Bank’s ability to act as an effective financial institution and mobilize incremental resources to finance priority needs in municipal infrastructure. This would be mainly accomplished by Iller Bank in leveraging its equity base through borrowings on long-term credit markets. Constraints to an Expanded Mandate for Iller Bank The ability of Iller Bank to carry out an expanded mandate and to contribute more effectively to the development of the municipal sector is constrained by a number of factors.
Iller Bank as a Municipal Infrastructure Finance Institution One option would be to build Iller Bank into a sustainable institution for municipal infrastructure finance able – along a clearly defined strategy – to play a pivotal role in the local government development process. In this context, the regulatory and institutional changes that have taken place over the past years, and the lowering of barriers to private sector entry into infrastructure services, may offer the adequate environment to redefine and strengthen the role of Iller Bank as a specialized intermediary for local government finance. The long-term objective in this case would be to build Iller Bank into a financially sustainable, well capitalized institution able to mobilize long-term credit on private markets for on-lending to economically viable local infrastructure investments. Even under such a scenario, the government may also want to assess the opportunity and feasibility of establishing separate windows at Iller Bank, where operations benefiting different categories (yet to be defined) of municipal borrowers may be subject to different financing criteria and conditions; these could range from high concession funding for small, resource-deprived, municipalities to loans carrying full market terms for larger, better endowed, entities. To provide a solid basis for the implementation of this option, a suggested path could be for Iller Bank to build upon its present activities of funding streams of municipal investments by successively:
Whereas the institutional and operational focus under (i) and (ii) would be on the asset side of Iller Bank (including portfolio quality and economic viability of local projects), the focus under (iii) would be mostly on the resource side with the aim of building Iller Bank’s capacity in mobilizing long-term credit – beyond budgetary and official bi/multilateral sources – on behalf of local governments. To improve the efficiency of resource transfer to local governments, Iller Bank would need to reassess the criteria on the basis of which it approves loans or grants to local governments; this should include inter-alia the selection of investment priorities. The aim would be to improve the quality of local investments in rationalizing the process in which budgetary and other funds are transferred to local governments. In addition to the goal of enhancing Iller Bank’s project financing mechanisms, benchmarks and criteria, the funding process – along specific and binding criteria to be applied by Iller Bank – would highlight the relevant parameters and the measures needed to lay the grounds for institutional strengthening and capacity building at the local government level. Examples of Sub-National Capital Finance Worldwide, there are many examples of functional financial intermediaries and municipal funds that support investments at the local level. Highlights of some examples are presented below. CanadaProvincial governments have free and uncontrolled access to borrowing on domestic and international markets. Municipal borrowing is subject to provincial scrutiny and approval. Once approval is granted, municipalities are free to borrow from the private sector. Although no additional role is required, provincial authorities can provide a variety of additional assistance including loan guarantees, transfers to cover loans, assistance in marketing of municipal debt, and loans. Some provinces borrow for the purpose of relending to small local governments. Mexico Mexico's National Solidarity Program (PRONASOL) is funded from an earmarked share of the national budget. Allocations are distributed among states by formula, with a fixed proportion earmarked for allocation by mayors. Allocations to municipalities are based in part upon political considerations. But within a given recipient municipal, the allocation of funds among projects draws upon a well developed system of negotiation between the mayor and community groups, in which PRONASOL funding is made conditional upon the community's willingness to provide counterpart contributions in cash or in kind. While mayors have the latitude to vary the terms of each project agreement, the matching requirement is universal. Colombia Colombia's municipal credit institution, Financiera de Desarrollo Territorial (FINDETER), does not lend directly to municipal governments but operates as an autonomous discount agency to private sector and state-owned commercial banks that make the loans, appraise the projects, and monitor performance. Under the control of the finance ministry, it has been relatively insulated from political pressures. The system's funding does not rely on government budgetary appropriation but rather on bonds, recycling of loans, and foreign credits from bilateral and multi-lateral sources. Colombia's decentralization process highlighted weaknesses in municipal financing. On the credit demand side, municipalities lacked credit records, accepted accounting practices, and financial planning capacity. On the credit supply side, long-term capital markets were undeveloped and banks lacked experience appraising municipal credit-worthiness. The success of FINDETER is based on two important parts of federal legislation: transfers to municipalities are formula-based which provides a predictable revenue stream and, under Colombia law, this revenue stream can be used as collateral for municipal loans. FINDETER is affiliated with the Ministry of Finance but has an independent corporate status. Employee salaries are in line with private sector banking benefits. Management is decentralized to 10 regional units. FINDETER’s main features: (i) Ownership: Federal and provincial governments are sole shareholders. (ii) Customers: Commercial banks with loans to local governments.
Issues for importing the FINDETER structure to other countries:
Australia The Australia Loan Council (ALC), established in 1927 as a central credit allocation mechanism for sub-national borrowing, was seen as an outmoded institution for the 21st century. The ALC now works as a coordinating agency for sharing information on federal-state-local fiscal positions and macroeconomic strategies. States are required to justify their borrowing plans for consistency with own fiscal needs and overall macro strategy for the nation as a whole. If these requirements are met, states are free to access financial markets for raising the required funds. United States Both federal and local governments have unrestricted access to capital markets. Municipalities, or municipal agencies, issue bonds. Creditworthiness of municipal offerings is determined by private rating companies. Federal and state governments promote bond issues through income tax exemptions on interest payments. PakistanPakistan's Annual Development Plan (ADP) process typifies a highly centralized system. The ADP process begins with a municipality's submission of a project proposal to the provincial government, where it is subjected to technical review; if technically approved, it is then included in a larger pool of projects eligible for financing. Financing decisions are made annually, and begin with an estimate of overall resource availability by the central government's Ministry of Finance. The provincial government then makes a tentative match of resources with projects; then forwards it recommendations to the central Government's annual plan coordination committee; which approves size and sectoral allocation of the overall package, and then submits it to the national economic council, presided over by the president. This lengthy process does succeed in eliminating technically unsound projects, and matches resources to projects, but incorporates no mechanism for weighing the degree of local commitment to investments projects. Enhancing Creditworthiness at the Local Level It would be necessary, in a further stage, to address the institutional and capacity building parameters that enhance creditworthiness at the local level. Thus the criteria and conditions applied by Iller Bank should seek to ensure that local governments drawing on Iller Bank's funding – which could increasingly consist of debt liabilities including budgetary as well as bi/multi-lateral resources – are able to service their loans out of the direct or indirect economic benefits generated by the investments funded by Iller Bank’s loans. As Iller Bank’s resources would have, increasingly, to be passed on to municipalities as loans with no government subsidies or guarantees, changes would be needed to help rationalize the borrowing practices at the local level and improve the quality of local investment programs. This might involve assistance to local governments in enforcing improved budgeting, financial control, auditing and disclosure standards and which would also provide other prospective lenders with reliable information that could allow meaningful credit assessment of local borrowers, and help municipalities build transparent credit records. Transition to a Market-based Municipal Credit SystemIf the government wishes to complete the transition to a market-based municipal credit system in which Iller Bank would play a pivotal role, further adjustments would be required so that Iller Bank may offer adequate pooling mechanisms that allow local governments to mobilize incremental financial resources on private markets for their investment programs. At that stage, such adjustments – covering Iller Bank as a financial institution and, as need be, the client municipalities – would allow Iller Bank to operate largely along market-oriented principles, in mobilizing long-term debt (with no government guarantee) for on-lending to economically viable, revenue-generating local infrastructure investments. In time, part of Iller Bank’s lending may be directed to investments in public goods that have demonstrated economic merits, along specific criteria, that would establish that municipal borrowers are able to generate the fiscal resources needed to service Iller Bank’s debt. Legal and Regulatory FrameworkFor such an option to be implemented successfully, it would be necessary to re-assess – in the context of an open and competitive financial system where all financial institutions may be involved in the municipal finance market – the legal and regulatory framework under which Iller Bank can engage in efficient financial transactions, building upon its comparative advantages among other institutions (e.g. being the repository of knowledge, data and indicators on local government operations and finance). Moreover, the main features of Iller Bank as a preferred lender for local governments would also have to be specified, including the elements and scope of public support that would be needed and acceptable to assist Iller Bank in accessing private long-term credit markets on behalf of local governments. In addition, the policy conditions needed to sustain healthy borrowings by local government clients would have to be defined. As the ability of municipalities to access credit markets depends on critical creditworthiness factors, attention would also be devoted to:
Moreover, alternative funding strategies for local infrastructure investments may need to be devised, including non-recourse project finance options that reduce contingent liabilities at the central government level. Iller Bank as a Self Sustaining Financial Intermediary For Iller Bank to operate as a self-sustaining financial intermediary and raise long-term resources on private credit markets, specific parameters would have to be incorporated in Iller Bank’s policy and operational guidelines. These should cover:
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