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					                                     Finance Forum 2004
                          Financial Intermediation Working Group1
                                      Draft Policy Note

                                         Table of Contents

Executive Summary

I.      The question posed to the working group
II.     Objective and scope
III.    Why Focus on long-term finance?
IV.     Summary of OED’s report on tThe Bank’s Financial Intermediary Lending
V.      Making aA.       All FILs case for FILs - The Zambia Multipurpose Credit
        Facilityand FILs
(i) Main findings
                 (ii) Recommendations
                 (iii)Conclusion and Main Messages
        B.       Municipal FILs
                 (i)     Main Findings
                 (ii)    Lessons learned
        C.       Microfinance FIL
                 (i)     Main findings
                 (ii)    Lessons Learned
VI.     OED’s Aassessment of Bank Operations in Improving Financial Intermediation
VII. Emerging long-term financing needs of clients
        A.       Example 1 - Emerging needs in Infrastructure Finance
                 (i)     Financing Needs
                 (ii)    Financing Models
                 (iii)   Financial intermediaries in infrastructure finance
                 (iv)    Impediments to capital market financing of infrastructure
        investments
                 (v)     Improving Financial Intermediation for Infrastructure Investments:
                         How the World Bank Group Can Help?
        B.       Example 2 - Emerging needs in Housing Finance
                 (i)     Financial intermediaries in housing finance
                 (ii)    Key issues in mobilizing finance for housing
                 (iii)   Pre-requisites for issuing mortgage securities that can finance housing
                 (iv)    Role of Government’s in developing mortgage securities
                 (v)     The Bank’s role in developing the housing finance sector
VIII. Financial intermediaries that can meet emerging needs
        A.       Case study 1 - Pension Funds in Chile
        B.       Case study 2 - Insurance firms ? (Rodney?)

1Members of the Working Group: P.S. Srinivas (World Bank, Jakarta); Priya Basu (World Bank, New Delhi);
Colleen Mascenik, Laurie Effron, Anjali Kumar , Susana Sanchez, David Scott, Michel Noel, Jacob Yaron,
Neesham Kranz, Ahmet Soylemezoglu, (World Bank, Washington); Heywood Fleisig (Center for Economic
Analysis of LawEAL, (CEAL),Washington)Priya Basu (New Delhi); P.S. Srinivas (Jakarta).
IXVIII.        Legal and regulatory constraints that affect both traditional and emerging
       needs in financial intermediation
IX.    Getting FSD back on the agenda
       Box: The case of Indonesia

XI.       Conclusion

Annex 1: Summary of OED’s report on Municipal FILs and Microfinance FILs


Box 1:    A case for financial intermediary lending: Lessons from Zambia
Box 2:    Case study of a good Municipal FIL
Box 3:    Case study of a microfinance FIL: Credit Amigo in Brazil:
Box: 4:   Getting FSD back on the agenda: The case of Indonesia




                                                                                            2
Annex 1: Assessment of DFI Performance




                                         3
                                   Finance Forum 2004
                        Financial Intermediation Working Group2
                                    Draft Policy Note

                                     Executive Summary

The working group was asked to examine the issue of how the Bank can assist in                      Formatted
best mobilizing financial resources for long-term funding needs of clients. The group
focused on two ways in which this objective could be met. First, the group reviewed the
Bank’s past experience with financial intermediary lending (FIL) as a mechanism to provide
clients with long-term external resources. In doing this, the group examined OED’ review of
past Bank FILs as well as a case study of an FIL that has had a positive impact. Second, the
group examined emerging needs of clients and how long-term domestic resources could be
mobilized to meet these needs. In the latter, the approach taken was on development of              Formatted
institutional investors such as pension funds and insurance firms.

The Bank’s past experience with past experience with using FILs to improve access                   Formatted
to term credit has not been very successful. OED’s review finds that outcomes of the                Formatted
loans as well as adherence to Bank guidelines have been poor. Across all FILs, better
outcomes were found to be associated with stable macroeconomic conditions, stronger
financial sectors, including satisfactory competition policies and good legal and regulatory
regimes governing financial institutions, mostly market determined interest rates, few
distortionary credit and tax policies, and limited state ownership of financial institutions. The
case study of an FIL in Zambia that has had a positive impact further stresses the
importance of several findings of the OED review. It emphasizes that sound design and
strong focus on implementation issues are key to “good” FILs. From these reviews and
experiences, the message that seems to emerge is that simply providing clients with long-
term resources as a strategy to mobilize such funding has not worked.

OED’s review of Bank activities aimed at improving overall financial intermediation
in many countries shows that while financial intermediation has improved in
countries where the Bank has been involved, the improvements in measures of
financial sector depth and access to credit have been relatively modest.
Macroeconomic factors such as high inflation and crowding out of private access to credit
by the government are some of the reasons for this modest achievement. However, evidence
suggests that institutional and environmental factors such as collateral laws, creditors’ rights,
strength of judicial system and the enabling environment for private investment or the
investment climate may also play critical roles. These low levels of financial intermediation
point to a need for the Bank to work with client countries to continue to identify and
remove constraints to enhancing the role of the financial sector in mobilizing resources,
channeling them to productive investments, and managing risks related to these roles. In
addition more work may be required institutional level i.e. improving financial institutions’
capacity to provide resources and manage risks. The Bank needs to focus its future
assistance in these areas so that the necessary institutions for successful financial
intermediation can be put in place.
Legal issues present particularly severe constraints and can prevent formal financial
institutions from delivering credit to what otherwise would have been considered
creditworthy clients. Unlike unsecured lending, secured lending rests on the capacity of
creditors to foreclose collateral in a convenient, inexpensive and quick manner. Problems
associated with inefficient laws, regulations and institutions responsible for this enforcement,
that fail to adequately protect creditor rights, result in formal creditors denying credit or
offering smaller loan amounts with higher lending rates than would otherwise be the case.
Substantial improvements in these areas require usually small value of resources. However,
when appropriately introduced, these improvements can contribute substantially to
augmenting the volume of financial intermediation as well as growth.

There is also a need for the Bank to be responsive to the question of what its future
financial intermediation activities should be, given the emerging challenges faced by
its clients. FILs channeled through DFIs and/or banks are the traditional way in which the
Bank has addressed financial intermediation. Several countries (especially middle income
countries) now recognize that the banking system may not necessarily be appropriate to
finance some emerging needs – such as those of infrastructure, housing, and financing sub-
national governments. Capital markets and non-bank financial institutions and institutional
investors such as pension funds and insurance firms may be more relevant financial
intermediaries than banks to meet long-term financing needs. In this context, therefore, the
Bank needs to broaden its view of financial intermediation activities and enhance support for
the development of these sources of long-term funding. International experience shows that
pension funds and insurance firms have played major beneficial roles in financial
intermediation aimed at long-term domestic resource mobilization.

Finally, the group addressed the broader issue of getting financial sector work back
on the overall Bank agenda – a challenge being faced especially in many middle
income countries and those that are not in a crisis situation. In many countries,
financial sector lending tends to be high during crises. Once they are past FS staff all over
the Bank face substantial budgetary pressures as the Bank moves from a crisis management
agenda to a poverty-focused development agenda. A case study of Indonesia – which has
had some recent success in this area - provides the following main messages. There should
be substantial focus on and input to the CAS – since active discussions during the CAS
preparation process probably do just as much to focus minds on the FSD agenda as the
actual document itself. FSD work should be tied in with other country and sectoral
priorities. FSD should be seen as a relevant partner across sectors and not just on a stand-
alone basis – especially in addressing emerging needs such as infrastructure finance, housing,
SME development, and microfinance that are core to the poverty reduction /growth agenda.




                                                                                              5
                                  Finance Forum 2004
                        Financial Intermediation Working Group
                                    Draft Policy Note

I.     The question posed to the working group

“Many of the regions face challenges in scaling up their financial sector lending operations,
and lending in the financial sector is lower compared to other sectors in the Bank. Lines of
credit have been declining in the financial sector, with a high cancellation rate, competing
sources of credit from other IFIs, and high transaction costs cited. However, financial
policymakers in developing countries still point to a gap in long-term financing. How can we
best mobilize domestic resources for long-term funding needs of clients, such as
infrastructure investment, SMEs, and rural finance? What are the possible solutions? What
institutions, institutional investors, and financial market frameworks are required? Looking
at current FI operations, what are the Bank's policies and best practices? Exploring the
prospects for various financial instruments, including operational experience from the
regions, what is the potential for: lending products, guarantee instruments, lines of credit,
guarantee products as capital market enhancement instruments (PCGs for corporate bonds,
municipal bonds, mortgage bonds, PRGs for locFILal utility bonds, etc.)? What works and
what doesn’t?”

II.    Objective and scope

The purpose of this note is to create a basis for discussion at the Forum on the issue of how
the Bank can assist in best mobilizing financial resources for long-term funding needs of
clients. In order to maintain focus and, considering the other sessions at the Forum that
discuss many of the other issues raised in the question posed to the group, the working
group decided to limits its scope to covering the following major avenues that either have
been or could potentially be utilized to provide long-term resources: (i) external sources –
focusing on Financial Intermediary Lending (FIL) by the Bank; and (ii) internal sources –
focusing on development of institutional investors such as pension funds and insurance
firms.

The term “financial intermediation” obviously is very broad in scope and covers a wide
range of financial institutions. Broadly speaking, financial intermediaries perform a variety
of roles including, among others, reducing transactions costs and information asymmetries in
bringing together borrowers and savers, creating liquidity, facilitating economies of scale in
investment, and engaging in risk management by pricing risk, engaging in risk transformation
and risk pooling. In an operational sense, nearly every institution in the financial sector that
the Bank works with, is a financial intermediary. Clearly, it is not within the scope of this
note to cover all institutions. In its FILs, the Bank has largely focused on working with DFIs
and banks. Given this emphasis, much of the note focuses on the Bank’s activities in FILs,
and discusses lessons learned and implications for design of future operations. In many of its
other activities, the Bank has worked with other financial intermediaries – for example,
capital markets, pension funds, and insurance firms. These are also intermediaries in the
development of which many countries are now expressing interest. The note takes the
perspective of how best these institutions can contribute towards mobilizing long-term
resources and proposes – for discussion - some areas of work that the Bank could consider
going forward.

III.    Why Focus on long-term finance?

Two competing views exist on the issue of long-term finance. The one held by many
development economists – as well as the Bank and other multilateral agencies for a long time
– has been that financial markets in developing countries do not provide adequate long-term
capital and that this is a key impediment to growth. A contradictory point of view - based
largely on developed country evidence – states that long-term debt is not necessary for
acquiring physical capital and firms may actually be better off without it (Diamond (1991,
1993) and Rajan (1992)). Caprio and Demirguc-Kunt (1997) examine the evidence from
developing countries and reach the following main conclusions. First, long term credit is
scarce in developing countries and in particular is scarce for small firms. Second, using
evidence from manufacturing firms, more long-term finance tends to be associated with
higher productivity. Third, subsidized long-term credit is not associated with higher
productivity. They conclude that “it is worthwhile for governments to attempt to foster the
supply of long-term credit, though it is crucial that these interventions be crafted with great
care – and little subsidy”.

More recently, there is renewed interest in the issue of long-term finance. As discussions
move beyond the kinds of financial instruments and institutions necessary to finance
traditional manufacturing firms – either large or small - several countries are beginning to
raise the issue of what sort of policy interventions are necessary in order to mobilize long-
term resources for financing infrastructure, sub-national governments, and housing, among
others. The question as to what role that non-bank financial institutions may have to play to
raise such resources is also being raised. In trying to arrive at a response to such questions of
governments, therefore, it is worth examining relevant approaches based on a broader view
of financial intermediation.

IV.     A summary of OED’s report on Tthe Bank’s Financial Intermediary Lending3

For much of its history, a significant part of World Bank (and other multilateral
development bank) financial sector lending was aimed at attempting to correct for the dearth
of term credit through the creation and encouragement of Development Finance
Intermediaries (DFIs), later through financial intermediary loans (FILs) extended through
DFIs and commercial banks.



FFILs have a long and contentious history in the Bank. Financial intermediary loans (FILs)
are funds passed through financial intermediaries that require repayment by the ultimate
users of the funds. Although they have been around since the 1950s, mention FILs within
the World Bank and immediately a debate ensues: they’re good instruments for overcoming
market failures, reaching the underserved private sector, and promoting growth and

3
 This section is based largely on from the OED Review of Bank Lending for Lines of Credit. Annex 1
presents a summary of OED’s findings on Municipal FILs and Microfinance FILs.


                                                    7
employment, they’re terrible instruments that introduce distortions, are unsustainable, and
crowd out private sector intermediaries. The debate has been driven in part by ideology; in
part by selective reviews; and by anecdotes and experience.

As early as the 1950s, the Bank based support for FIL on the presumption that market
imperfections existed, and that Bank lending could help overcome constraints on access to
credit, and in particular, to foreign exchange. It was only in the 1980s that the Bank began
to question whether the instrument was being used under the right circumstances and to
good effect4. By the late 1980s, consensus was building among the Bank’s specialists that
FIL should be put in place only in countries that meet certain preconditions – such as
macroeconomic stability and sound financial sector prudential regulation and strong
supervision – and only at unsubsidized interest rates, to financial intermediaries that meet
minimum eligibility criteria. These views were formalized in 1992 in Operational Directive
(OD) 8.30, which covered investment as well as adjustment lending in finance.
                    Figure 1: FIL Commitments and Number of Projects

                  3000

                  2500
                                                22

                  2000
                                  22
                                       18
             $M




                  1500
                         17                                                            19
              1 1000                                      18
              7                                                           21
                  500                                            22
                              5             7               10                                  9           8   6 6    7
                                                                      8        8            9
                                                     1                                              9   4                  2
                    0
                         1993          1994     1995      1996   1997     1998         1999     2000    2001    2002   2003

                                                         Regular LOC               Micro LOC




A 1974 study of delinquency rates in agricultural lending institutions reported that the
average arrears rate was 41 per cent, while a 1983 report indicated that 39 percent of the
DFIs were experiencing serious portfolio problems while another 53 percent were
experiencing moderate problems (World Bank, 1974, and Siraj, 1983). OED has taken up
another – more comprehensive - evaluation of such loans during the FY 1993-2003 period.
Focusing on this most recent study, over the FY93-03 period, US$13.4 billion were
approved for FILs, representing 8.4 percent of total Bank commitments for investment
lending. The trend in commitments has been sharply downward, however, continuing the
trend that started in the mid-1980s; lending for FIL has decreased from some 10 percent of
total Bank commitments in the early 1990s to well under 2 percent in FY02-03. Although
FILs are embedded in projects in most sectors, the bulk of the FIL are in the rural and
financial sectors and municipal lending, and involve a wide range of designs, objectives, and
arrangements.



4These views were reflected in the Report of the Task Force on Portfolio Problems of Development Finance Companies,
Report no. 4772 (October 1983) and the Levy Report of 1989.


                                                                                   8
                       Table 1: Sectoral distribution of FILs, by number of
                       operations, FY93-03
                       Sector                     Percent     Percent     Percent
                                                  all FIL     regular      micro
                       Rural                       31.4         26.4       42.5
                       Finance                     16.9         20.2        9.6
                       Urban                       14.0         19.0        2.7
                       PSD                          9.7         11.7        5.5
                       Social Protection            9.7         3.1        24.7
                       Energy                       4.7         4.3         5.5
                       Environment                  3.8         4.3         2.7
                       Water and Sanitation         3.0         3.7         1.4
                       Other*                       6.8         7.4         5.5
                       Total                        100         100         100
                      *public sector, transport, economic policy, education, HNP


Main findings and recommendations

      Adherence to Bank guidelines for lines of credit (OP 8.30) has been poor, in terms of approving
       FILs under poor conditions, with inadequate attention and analysis of the
       participating financial intermediaries.
      Outcomes are poor, with high cancellations. More than 40 percent of original commitments          Formatted
       have been cancelled, and outcome ratings of closed FILs are unacceptably low (52
       percent satisfactory by number and 45 percent by net commitment).                                 Formatted
      Better outcomes for FIL are associated with:

            stable macroeconomic conditions;
            stronger financial sectors, including satisfactory competition policies and
             good legal and regulatory regimes governing financial institutions, and mostly
             market determined interest rates, few distortionary credit and tax policies,
             and limited state ownership of financial institutions;
            use of clear eligibility criteria in the selection of participating financial
             institutions;
            sound analysis by the Bank, as well as reasonably reliable data on financial
             performance and portfolio quality from the intermediaries and an external
             audit to verify the data;
            better efforts to measure subsidies and to discuss their magnitude and the
             policies underlying them with government;
            a minimum set of key indicators established during appraisal and monitored
             during supervision, including a measure of the quality of the loan portfolio,
             with clear definitions, and other key ratios (such as capital adequacy)
             established by the prudential norms in the country.
            use of only private sector financial intermediaries; and
            smaller lines of credit are associated with lower cancellation rates.                       Formatted
                                                                                                         Formatted: Bullets and Numbering
      OED’s main recommendations are:


                                                 9
                 Guidelines for FILs should be updated to ensure that all FIL components
                  and FIL projects, regardless of their type or purpose, follow the guidelines,
                  and to reflect developments in financial instruments and risk management
                  techniques (particularly with respect to foreign exchange risk). Mechanisms
                  should be established to ensure that the updated guidelines are followed.
                 All FIL components should be systematically identified in all Bank funded
                  projects as part of the basic information on the project, and the FIL
                  guidelines should apply to all FIL components and projects, as this analysis
                  has shown that FIL that do follow the current guidelines have better
                  outcomes. If the costs of applying them appear to outweigh the benefits
                  given the scope of the FIL, then the FIL is not the appropriate instrument
                  for meeting the objectives of the component.
                 Conservative estimates of the demand for funds and sizing the FIL to be a
                  modest fraction of that demand can help reduce the probability of poor
                  disbursements.
                 Bank management needs to harmonize its approach to funding FIL with that
                  of other donors, particularly MDBs. In-country aid coordination should
                  focus on better coordination in practice.
                 QAG should use Bank guidelines in its Quality at Entry reviews and its
                  ratings should reflect the extent to which the guidelines are respected.
                 The Financial Sector Network should ensure quality control during the
                  appraisal process. All Regions should adopt a practice of review of FIL
                  components by their financial sector staff.
                 For projects that have a significant FIL (at least 30 percent of the loan/credit
                  amount), OED should expect to find information on basic key indicators
                  such as repayment rates, portfolio quality, and some measure of the subsidies
                  involved, in Implementation Completion Reports (ICR). In the absence of
                  these indicators, OED should not consider the ICR satisfactory nor the
                  outcome of the FIL satisfactory.

V.         Making a case for FILs – the Zambia Multipurpose Credit Facility5                         Formatted
                                                                                                     Formatted
In spite of the downward trend in Bank lending for FIL and the problems associated with
them, as highlighted in several reviews, they are unlikely to disappear as a form of bank
support to countries. The following case study presents an example of a successful FIL. In
addition to the lessons learned from OED’s review, elements of this positive experience
could also be relevant to improve the quality of design and outcomes.



The Enterprise Development Project (EDP) served as the World Bank’s main PSD (Private
Sector Development) and FSD (Financial Sector Development) instrument in Zambia
between 1998 – 2003. Total amount of IDA resources that were made available under this
project was $45 million, of which $40 million funded a credit line component (multi-purpose

5   For further details see Soylemezoglu, A. – A case for FILs.


                                                         10
credit facility -MCF) of the project. EDP achieved significant success in Zambia. The
project’s design, implementation and performance have attracted considerable attention both
inside and outside of the Bank.

The EDP’s main objectives were to: a) create a mechanism to channel investment and
export finance; b) improve financial system regulation; and c) stimulate policy response in
the economy by facilitating a broad-base private sector investment and production of
exports. A $2.5 million matching grant facility and a $2.5 million technical assistance
reinforced the EDP’s $40 million MCF component. Matching grants were offered to partly
finance transfer of new technologies on a grant basis while technical assistance aimed to
support capacity building in the financial sector particularly financial system regulation and
supervision at the Bank of Zambia. A small Apex unit within the Bank of Zambia, specially
created for the MCF, managed the facility. The credit line was entirely denominated in
dollars and euros with no specific on-lending interest rates but a $3 million maximum limit
on the loan size. EDP also contained an innovative sinking fund mechanism where part of
the interest on MCF funds is invested to pay off IDA loan.

The results achieved by the MCF are quite impressive. The MCF funds have become a main
source of investment lending in Zambia as total MCF funded loans now constitute about
fifteen percent of total lending to the private sector by Zambian banks and leasing
companies. The MCF funded loan portfolio of the financial sector has now attained
systemic importance and indirectly helped the fiscal position by making more room for
banks to hold treasury bills, and hence lessening the degree of “crowding –out”.

The MCF succeeded to: (i) contribute to the diversification process of Zambian economy;
(ii) spread out financial resources across the entire spectrum of firms; (iii) create jobs,
generate corporate and tax revenue and export proceeds; and (iv) contribute to the
development of financial sector. The MCF funded 192 projects by lending about $60
million by recycling repayments. Agriculture related activities were the main beneficiary of
the MCF, receiving almost 44% of total loans while mining related loans were only 12.4% of
total loan disbursements. One third of the loans were less than $100,000 and they financed
small-scale projects. There were only six loans above $1 million corresponding to 13% of
total lending. Although the following overall impact data of employment, tax and corporate
revenue and export proceeds is highly remarkable, the actual impact is far bigger than these
numbers suggest as there was considerable indirect impact. Remarkably, the Apex did not
experience any default or arrears.

                             Table 2: Summary Impact Data
Number of projects                          192 projects totaling about $60 million
Number of Jobs Created                      Approximately 6,000
Revenue Generated                           US$ 60 million
Tax Collected                               US$ 11 million
Exports made                                US$ 15 million

The EDP’s impact on financial sector is considerable: (i) it created a viable mechanism to
channel investment finance resources in Zambia through a highly cost effective apex
mechanism; (ii) it provided long-term funding resources to Zambian financial institutions


                                             11
which did not have access to such resources prior to the EDP; (iii) it helped Zambian
financial institutions to generate capacity to evaluate investment projects; (iv) it promoted
compliance with prudential requirements; (v) it helped to creation of viable leasing sector by
making leasing companies eligible participants; (vi) it assisted improvement of legal and
regulatory framework as well as skill building in the financial sector; and (vii) it influenced
the Donor behavior as EIB replicated EDP’s design and offered additional facilities. In
addition to these benefits, the government assumed no commercial risk as all the lending
was done at the risk of financial institutions.




                                              12
13
B.                 Municipal FILs

As decentralization gains ground in many countries, providing access to long-term funds for
municipalities and, more broadly, sub-national governments is being increasingly stressed by
many governments. A recent internal Bank report on enhancing support to middle income
countries recommends making greater use of lending for infrastructure through FIL to sub-
national level governments (mainly municipalities). Historically, the Bank – largely through
its Urban Sector Operations - has provided lines of credit that could be accessed by
municipalities. This section reviews the lessons of this experience

During the FY 1993-03 period, out of a total number of 169 regular FILs, 34 projects (20
per cent) included a municipal FIL component, which represents 20% of the FIL-
commitments of all regular FILs. The municipal FILs were mostly developed within the
Urban Development Sector of the World Bank (22 projects, 65%)6 and covered a multitude
of sectors, which can be generally labeled as “urban infrastructure”. Only two closed projects
had a sectoral focus, specializing either on Water Supply or Solid Waste. The following
analysis is mainly based on the outcomes and findings of the 13 closed projects, but includes
information from the remaining open projects where available.

Figure 2

                              Annual Appraisal of municipal LOCs
                                           FY93-03

                   1000                                             8
     million USD




                    800                                             6         FIL commitment
                    600
                                                                    4         Number of LOC
                    400
                    200                                             2
                      0                                             0
                          93 94 95 96 97 98 99 00 01 02 03
                                        Year



Main Findings

      The focus of the municipal FILs was mostly on mobilizing new resources to increase                       Formatted: Bullets and Numbering
         much needed investments in infrastructure and on improving the efficiency of the
         municipalities in delivering services. Additionally, most projects also addressed
         smaller objectives such as increasing the institutional capacity of the PFI, advocating
         intergovernmental reforms, improving the environment and attracting private
         investment. Over 60% of the closed projects had a significant grant elements, and
         the average grace period for the on-lend funds was around 3 years.


6 The other main WB sectors were: Water (5 projects), Environment (3 projects), Transport (1 project), Social
(1 project), Rural (1 project), Finance (1 project)


                                                      14
    Over 60% of the projects in the sample of closed projects channeled the WB funds
       through a financial intermediary7. The one financial intermediary chosen was either
       an autonomous Municipal Development Fund or a public Financial Institution who
       specialized in the provision of resources to municipalities and public enterprises. The
       decision to include only one financial institution in the project was frequently due to
       the lack of interest of commercial banks in municipal finance and the need to include
       subsidies in view of the fragile financial conditions of the municipalities.
    The outcome ratings for municipal FILs components compare favorably with the
       outcome of all regular closed FILs (see Table……). The ratings are mostly based on
       the positive real sector outcome of the municipal FILs.
       Table …: Outcome Ratings of municipal FILs compared to Regular FILs
       Number of rated No. (%) of projects No (%) of projects No (%) of projects
       projects               with     Satisfactory with      Substantial with           likely
                              outcomes               IDI                  sustainability
       51 regular FILs        24 (47%)               20 (39%)             31 (61%)
       13 municipal FILs 9 (69%)                     4 (30%)              7 (54%)
    Only a limited number of projects achieved all or most of their stated objectives (see                    Formatted: Bullets and Numbering
       Figure …. . While mobilizing resources has mostly been achieved, only limited
       results were reported in the remaining fields. Particularly improving efficiency in
       resource management has been difficult to achieve. In some cases, municipalities
       have been reluctant to borrow for technical assistance. In others, suggested reforms
       and improvements were not implemented at all or only half-heartedly. Improved
       cost recovery, albeit discussed or aimed for in the majority of appraisal documents,
       was frequently not achieved.


                                        Figure 3: Achievement of Objectives
                                           (in number of municipal LOCs)

       14     12           12
       12
       10          8
                                                       7           7
                                                                                            Objective at PAD
        8                                   6
                                    5                                                       achieved
        6                                                              4
                                3                              3               3            partly achieved
        4                                       2 2        2               2
        2              1                                                           1
                                                                                       0
        0
             Resource   Impr.              intergov.     FIN       Environ.    Private
               mob.   Efficiency           Reforms     reforms      Impr.      Sector



    Overall cancellation rates for municipal FILs (50% of the committed amounts were                          Formatted: Bullets and Numbering
       cancelled compared to 54% for regular FILs) appear to be in line with the outcomes
       for the total set of regular FILs. However, excluding two dominating projects in

7The remaining projects channeled funds either directly from the Government to the municipalities or used a
non-autonomous Municipal Development Fund to on-lend the funds.


                                                       15
         Mexico that were both adversely affected by the macroeconomic shock of 1995, the
         remaining sample of closed municipal FILs had a disbursement rate of 93%, high
         even in comparison with Bank average (78%). This high disbursement rate is also
         reflected in the good outcome rating of the municipal FILs.
     This comparatively encouraging outcome might not be sustainable. Low ratings for
         sustainability and modest institutional development combined with difficulties in
         cost recovery and fiscal decentralization suggests that the overall outcomes will be
         less positive on the long run. Additionally, overall disbursement rates for the open
         sample of municipal FILs fell to an average of 45%, with 71% of the projects closing
         this fiscal year or in FY 2005.
     Only limited quantitative information on the financial situation of the PFIs or the
         Municipal Funds is available at appraisal or completion.8 Additionally, none of the
         projects complied with the requirement to compute the subsidy dependence of the
         PFIs, albeit significant amounts of subsidies being channeled through these public
         institutions. Information on lending interest rates is mostly provided in appraisal
         documents, but not during supervision and competition. The foreign exchange risk is
         also covered insufficiently. These shortcomings frequently hinder an assessment of
         the impact of the FIL on the financial viability of the PFI.
     Information on repayment rates were provided in 61% of ICRs, with only two out of
         these 8 projects suffering from substantial shortcomings in collection rates.
         However, this information has to be treated with caution since the grace periods of
         on average 3 years and the frequently high percentage of grant elements might have
         positively influenced this outcome.

    (ii) Lessons learned

     Establishing a sound intergovernmental finance system with appropriate incentives is                         Formatted: Bullets and Numbering
        critical. Increasing the capacity of municipalities to borrow for investment has to be
        embedded in a greater financial decentralization to ensure long-term sustainability of
        the municipalities.
     Cost recovery on the FILal level is frequently difficult to achieve. Not only in there a
        lack of political commitment, but poorer and smaller communities often face
        difficulties increasing taxes or utility charges. In the absence of grant elements or
        intergovernmental transfers, these shortcomings will limit the municipalities’ long-
        term capacity to borrow and service their debt.
     Evaluation and monitoring systems have to improve to raise efficiency of resource
        management and to provide better information on outcomes of investments.
     Overall, achieving more efficient resource management on the municipal level is a time-
        consuming process. Nevertheless, managerial, technical and financial should be
        provided within the loans.




8 4 out of 7 projects reported on the loan collection rates at appraisal, but only three at completion. Two
projects discussed adequacy of loan provisioning at appraisal and two at completion. Traces of audited financial
statements are visible in 4 PADs, but none in completion reports.


                                                      16
C.        Microfinance LOC

Sixty nine microfinance lines of credit (MLOC) approved during 1993-2002 were reviewed,
including 42 ordinary microfinance lines of credit (OMLOC) and 27 revolving funds (RLF),
amounting to a total of $1,405.4 million9, an average annual commitment of about $140
million that oscillated between $20 and $328 million during the reported period of FY 1993-
2002. The number of MLOC projects increased by about 46% in the FY 1998-2002 period
over the FY 1992-1997 period, while the total MLOC commitments increased by only 30%
for the same period, indicating a significant reduction in the average commitment size in the
latter period. Also notable was the five-fold increase in the amount of commitment of RLF
projects in the second half of the reported period while the amount of OMLOC
commitments declined. For the 3 years at the start of the reported period, FY 1993-95, the
average MLOC commitments accounted for less than 5% of total Bank lines of credit
(TLOC) commitments, but in the last 3 years, FY 2000-2002, the average MLOC
commitment share increased to about 35% of TLOC commitments. The substantial surge in
the share of MLOC commitments of TLOC commitments from less than 5% to about 35%
in the FY2000-2002 over FY 1993-1995 is explained by two factors. The first is that the
Bank has increasingly underscored poverty reduction as its primary goal and MLOCs were
increasingly considered by many as efficient, cost-effective instruments in fighting poverty.
The second is the widely spread information disseminated among donors, Governments
PFIs, NGOs and target clientele regarding the successful outcomes of salient microfinance
institutions (MFIs) in pursuing extended outreach and self sustainability.

The cancelled project amounts were about 38% of closed MLOC project commitments and
about 9% percent of closed MLOC projects approved. These percentages are below the
exceptionally high rate of cancellations found in RLOC projects where 46% of RLOC
commitments were cancelled.

Table 3: WB Projects with MF Component Commitments

                                                               A                 B                 C = B/A
                                                               Total          Microfinance         Microfinance
                                                   Number      World     Bank Component            Component as a
                                                   of          Commitment Commitment               %    of    Total
Description                                        Projects    (in millions) (in millions)         Commitment
MLOC Projects covered in the Study                 69          3,362.8           1,405.4           41.8%
    Active and Post FY97 Projects                  48          2,443.3           836.9             34.3%
    Closed and Pre-FY98 Projects                   21          919.5             568.5             61.8%

MLOCs were affiliated with all sector Boards. The majority of the OMLOC projects were
over sighted by the rural and social sector Boards, accounting for two thirds of the number
of projects (28) and about 54% of total commitments. The financial sector Board provided


9 The total number and commitment amounts of MFIL projects reviewed in this study differ somewhat from the statistics
used in the related study of Bank RFILs. That study cites 67 MFIL projects with a total commitment of $1,222.4 million
after cancellations. Part of the difference is that the MFIL study used the total MF component amount of commitment
while the RFIL study used only the FIL.


                                                          17
over sight to 7, or 17% of the total OMLOC projects that accounted for 41% of the
OMLOC commitments.

A different distribution pattern was found with respect to RLF projects where no project
was affiliated with the financial sector Board. Almost all RLF projects were over sighted by
the rural, urban and social sector Boards, accounting for 85% of total RLF projects
combined and about 99% of the RLF commitments combined. Data on the sectoral and
regional distribution of the MLOC projects and related commitments are presented in the
following tables.

Table 4: Sectoral Distribution of MLOC Projects

              OMLOC                                 RLF
Sector
              # of proj   $ comm      % comm.       # of proj   $ comm.      % comm
Energy        2           7.1         0.7%
Environ       1           8.6         0.9%          1           1.5          0.4%
Financial     7           405         40.6%
Health                                              1           1.9          0.5%
Public                                              2           0.4          0.1%
Private       4           36.2        3.6%
Rural/Ag      18          462.9       46.5%         14          171.6        42.0%
Social        10          76.7        7.7%          7           98.8         24.2%
Urban                                               2           134.7        32.9%
Total         42          996.5       100.0%        27          408.9        100.0%

The main lessons from the Zambia case study include : (i) Implementation issues are key to        Formatted
successful FILs (ii) FILs should be designed with maximum degree of customization to local        Formatted
conditions and be kept as simple as possible (iii) FILs should be linked to broader country       Formatted
programs and policies (iv) Detailed knowledge of the real and financial sectors is essential      Formatted
for designing FILs (v) FILs should be done only if expected returns justify risks (vi) Sound
                                                                                                  Formatted
participating financial intermediaries are key to success of FILs (vii) There needs to be an
                                                                                                  Formatted
appropriate role for regulators (viii) Political risk is a very real aspect of FILs. (ix) Local
ownership and trust are key to success.                                                           Formatted
                                                                                                  Formatted
                                                                                                  Formatted
                                                                                                  Formatted
                                                                                                  Formatted




                                               18
VI.   OED’s Assessment of Bank                      Figure 2 Financial sector depth, public confidence, and access
Operations in Improving Financial                   to credit in countries that borrowed from the Bank for
                                                    financial reforms, 1992-2002*
Intermediation
                                                                                                       100
Beyond FIL-related lending, the Bank                                                                    90
                                                                                                        80
has been involved in supporting



                                                                        M2 as % of GDP
                                                                                                        70
                                                                                                        60
financial sector reforms aimed at                                                                       50

improving         overall       financial                                                               40
                                                                                                        30
intermediation in many countries.                                                                       20
                                                                                                        10
Among the many objectives supported                                                                      0

Bank, two directly related to core issue                                                                  92

                                                                                                          93

                                                                                                          94

                                                                                                          95

                                                                                                          96

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                                                                                                        20

                                                                                                        20

                                                                                                        20
of this note is that of improving                                                                            Bank Borrow ers    OECD Countries*
financial sector depth and access to
credit. This section briefly reviews the
                                                       Cash and Demand Deposits as % of M2




                                                                                                       100
Bank’s experience in this area.                                                                         90
                                                                                                        80
                                                                                                        70
Over the 1993-2003 period, financial                                                                    60
depth as measured by the money supply                                                                   50
                                                                                                        40
(M2/GDP)10, grew modestly, from an                                                                      30

average of 30 percent of GDP to about                                                                   20
                                                                                                        10
36 percent, as shown in Figure 2.                                                                        0

Although still far from levels of OECD
                                                                                                          92

                                                                                                          93

                                                                                                          94

                                                                                                          95

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                                                                                                          98

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                                                                                                        19

                                                                                                        20

                                                                                                        20

                                                                                                        20


countries, regression analysis shows that
when country factors (such as growth                                                                          Bank Borrow ers   OECD Countries*

rate, fiscal deficit, inflation rate, and a
                                                       domestic credit to private sector as % of GDP




                                                                                                       120
measure of policy and institutional
                                                                                                       100
quality) are taken into account, the
                                                                                                       80
annual growth rate of M2/GDP in
                                                                                                       60
countries borrowing for financial sector
                                                                                                       40
reforms was higher than for Bank
clients who did not borrow over this                                                                   20


period for financial sector reforms.11                                                                  0
                                                                                                          92

                                                                                                          93

                                                                                                          94

                                                                                                          95

                                                                                                          96

                                                                                                          97

                                                                                                          98

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                                                                                                        20

                                                                                                        20

                                                                                                        20




The second indicator of financial sector                       Bank Borrow ers OECD Countries
depth is the level of public confidence
                                              *Excludes countries in euro area
in the banking system, as measured by         Source: IFC and WDI, 2004
cash plus demand deposits as percent of
M2: it should decline as confidence in banks grows and the public is willing to put a larger
portion of their resources in term deposits. Figure 2 shows that this measure also moved in
the right direction, but also modestly: cash and demand deposits as a proportion of the
money supply declined slightly from 51 percent to about 45. Here, the results are
converging to OECD levels, although this may be the result of growth in alternative forms

10
  M2 is the combination of cash, demand deposits, and time deposits (IFS, lines xx and xx).
11
  The difference was not statistically significant in the basic model, but was significantly different in two
of four variations on the basic specification.


                                                      19
of deposits outside of the banking system in OECD countries, rather than as a result of a
loss of confidence in banking services. In addition, countries that borrowed from the Bank
for financial reforms did better on this measure of financial depth than did Bank client
countries that did not borrow for financial reforms over the period.

Third, access to credit, measured by claims on the private sector by the banking system,
remained almost flat over the period (25.2 to 26.5 percent), and the gap with OECD
countries widened considerably. On this measure, when country factors are taken into
account, the annual growth rate of access to credit by the private sector was higher in Bank
client countries that did not borrow from the Bank for financial sector reforms than in the
borrowing countries. One explanation may be that within the group of Bank borrowers, the
more rapid bank privatization and establishment of higher standards of prudential norms –
requiring stricter loan classification and provisioning, higher capital ratios, and stricter rules
on interest rate accrual – may combine to foster more prudent lending.

The trends discussed above mask wide variations. Table 3 shows the distribution of changes
in countries where data were available. Although M2/GDP increased in most countries in
the sample, it fell for almost one third of them (19 out of 63 countries). In addition, for
another large group of countries, M2/GDP increased by less than 10 percentage points.
Public confidence actually fell in over a third of the countries, and increased by very little in
another fourth of them. Access to credit actually fell in about 40 percent of the countries
that borrowed from the Bank and increased by less than 10 percentage points for another 40
percent. This may because countries were more likely to borrow where the financial sector
was experiencing difficulties, but it shows that Bank lending for financial sector development
resulted in at best a modest and, by some measures, imperceptible change in the scope of
financial intermediation.

 Table 3: Distribution in changes in financial sector measures among countries that
                 borrowed from the Bank for financial sector reforms

                                     Change in indicator between 1992-94 and 2001-02

Percentage point increase            >20     10-19.99      5-9.99         0-4.99            <0        Total
                                     Number of countries
M2/GDP                               11      7             15             11                19        63
Credit to private sector/GDP         4       7             12             13                25        61
     Percentage point decrease       >0      0 - (-4.99)   (-5) -    (-   (-10) –      (-   < (-20)
                                                           9.99)          19.99)
Cash      and               Demand   17      15            13             12                5         62
Deposits/GDP
In addition, after more than 15 years of reforms supported by the Bank (10 years in ECA),
financial sectors remain shallow in many countries. At end 2002, financial sector depth, as
measured by M2/GDP, remained below 20 percent in 18 out of 64 countries, and access to
credit remained at a very low 10 percent of GDP in 19 out of 63 countries.12

12
  At the high end for M2/GDP are Morocco (87 percent); Slovak Republic (64 percent); and Philippines
(57 percent); and for access to credit, Tunisia (68 percent); Morocco (54 percent); Philippines (40 percent).


                                                            20
Reasons for this low level of financial intermediation include macroeconomic influences.
Financial sector depth is notably lower in high inflation countries than in low inflation
countries, and private access to credit can be crowded out by government’s need for
financing, in turn related to fiscal deficits. Finally, institutional and environmental factors
such as collateral laws, creditors’ rights, strength of judicial system; and in particular the
enabling environment for private investment may play critical roles in the willingness of
banks to extent credit. Nevertheless, these low levels of financial intermediation point to a
need for the Bank to work with client countries to continue to identify and remove
constraints to enhancing the role of the financial sector in mobilizing resources,
channeling them to productive investments, and managing risks related to these roles.

These constraints may be at a systemic level, identified by the Bank and researchers in the
economic, legal, and judicial areas – macroeconomic stability and fiscal deficits; collateral;
creditor rights; efficiency and transparency of legal processes. The investment climate may
also be wanting, and the political environment may not be conducive to strong demand or
willingness to lend long-term. In addition, however, more work may be required at the
institutional level: the banks’ own capacities to lend and to manage risks. Even after
governance and market structure have changed, interest rates liberalized, and prudential
regulations and banking supervision strengthened, if the banking staff and managers have
little experience in banking, technical assistance, training, and demonstrations of
successful lending may be required, aimed specifically at lending and risk
management techniques.

The challenges faced by FILs have already been discussed above. FILs may remain a key
product of the Bank for several countries. To the extent that FILs have been routed through
specialized (state owned) DFIs, the problems with DFIs also create problems for FILs.
Annex 1 discusses issues relevant to evaluating the true costs and subsidies related to
products delivered by DFIs.

VII.   Emerging needs of clients

FILs channeled through DFIs and/or banks are the traditional way in which the Bank has
addressed financial intermediation. Going forward, the Bank also needs to be responsive to
the question of what its financial intermediation activities should be, given the emerging
challenges faced by its clients. Many countries now recognize that the banking system may
not necessarily be appropriate to finance some emerging needs – such as those of
infrastructure, housing, and financing sub-national governments. For example, four
countries in East Asia – at very different levels of overall financial sector development – are
very similar in their structure of bank liabilities (Table 4) – 85% or more of all bank deposits
in all countries - are less than a year in maturity. With this structure of liabilities, prudent
asset-liability management would impose constraints on the amount that banks could invest
in long-term assets – a challenge that increasingly faces many Bank clients.

                                             Table 4
                             Structure of bank liabilities (% of GDP)
                                                   Indonesia Malaysia   Thailand Singapore




                                               21
         Bank deposits with maturity less than 3
         months/total deposits                   92.1%          56.2%      73.8%     84.8%
         Bank deposits with maturity less than 1
         year/total deposits                     98.8%          92.9%      85.9%     97.2%
         M2/GDP                                  45.8%          108.1%     100.3%    138.7%
         Claims on private sector of banking
         system/GDP                              20.4%          96.6%      79.2%     112.0%

Interestingly, these four countries have different levels of development of NBFIs (Table 5 ),
which in turn partly explains the differing levels of access to long-term capital in these
countries. For eg: Malaysia’s pension funds have played a big role in financing its
infrastructure.




                                               Table 5
                              Structure of the financial sector (% of GDP)
                                            (December 2003)
             Assets                         Indonesia Thailand Malaysia        Singapore
            Commercial banks                56.0%         114.9%     159.8%    233.4%
            Insurance firms                 4.2%          3.4%       19.5%     49.8%
            Mutual funds                    3.3%          12.2%      20.1%     20.0%
            Pension funds                   1.8%          4.8%       56.4%     65.7%
            Stock market capitalization     22.1%         79.4%      162.2%    162.3%

In certain countries, cCapital markets and non-bank financial institutions and institutional
investors such as pension funds and insurance firms may be more relevant financial
intermediaries than banks to meet long-term financing needs. In this context, therefore, the
Bank needs to broaden its view of financial intermediation activities. The issue that needs to
be addressed is what sort of activities the Bank can undertake in order to promote financial
intermediation by capital markets and NBFIs. This section provides a brief overview of two
areas of emerging needs – infrastructure and housing finance – and discusses ways in which
the Bank can assist in channeling financial resources to these areas. This discussion is purely
illustrative and not exhaustive. There are potentially several other areas where financial
intermediation through capital markets and NBFIs is relevant.

A.      Emerging needs in Infrastructure Finance13

(i)     Financing Needs


13
 This section is largely extracted from Marathe, Noel, and Sirtaine (2004). “Making Capital Markets
Work for Infrastructure Finance”.


                                                   22
Over the 2005-2010 period, infrastructure investment needs in developing countries are
projected to amount to $ 465 billion annually (Table 6)14. These investment needs are driven
by projected increases in population, increased coverage of existing population, repair and
rehabilitation needs, and increased compliance with environmental standards.




14
  Marianne Fay and Tito Yepes, Investing in Infrastructure: What is Needed from 2000 to 2010? World
Bank Policy Research Working Paper 3102, July 2003



                                                23
                                                         Table 6
                                   Expected Annual Investment Needs (1) in Infrastructure
                                              Emerging markets – 2005-2010
                                        New                      Maintenance                                       Total
Developing      Countries           by US$Mn         % GDP 3     US$Mn          % GDP 3                            US$Mn             % GDP 3
Region
East Asia & Pacific                        99,906            3.67              78,986            2.90              178,892           6.57
Europe & Central Asia                      39,069            2.76              58,849            4.16              97,918            6.92
Latin America & Caribb.                    37,944            1.62              32,878            1.40              70,822            3.02
Middle East & N. Africa                    14,884            2.37              13,264            2.11              28,148            4.48
South Asia                                 28,069            3.06              35,033            3.82              63,101            6.87
Sub-Saharan Africa                         13,268            2.84              12,644            2.71              25,912            5.55
All developing countries                   233,139           2.74              231,654           2.73              464,793           5.47
     Source: Marianne Fay and Tito Yepes, Investing in Infrastructure: What is Needed from 2000 to 2010? World Bank Policy Research Working
     Paper 3102, July 2003. Notes:
     1 Predictions are based on estimated demand rather than on any absolute measure of "need“
     2 Infrastructure includes roads, railroads, telecommunications, electricity, water and sanitation.
     3   GDP deflator used is an average of the 2005-10 projections.




     (ii)       Financing Models

     Governments and sub-sovereigns may follow two alternative approaches to finance
     infrastructure investments, i.e. the public finance model and the Public-Private Partnership
     (PPP) model.

     Under the public finance model, sovereigns and sub-sovereigns borrow on their own
     account through loans or bond issues. These borrowings are counted against general
     government debt and the capacity of governments to take on debt has varied widely – with
     concomitant impact on ability to finance infrastructure through public finance.

     In the PPP model, sovereigns and sub-sovereigns seek the participation of the private sector
     in infrastructure through various Public-Private Partnerships (PPPs) such as management
     contracts, leases, concessions, BOOs, BOTs and divestitures. Concessions, BOOs and
     BOTs involve the setting up of a special-purpose company that is responsible for
     investments and operations of the infrastructure service. To the extent that the private


                                                                       24
investor has a majority stake in the equity of such company, borrowings to finance
infrastructure investments are no longer part of general government debt. This also applies
in the case of divestitures where private investors take a majority equity stake in an existing
infrastructure company. In these cases, the PPP model enables sovereign and sub-sovereign
governments to resolve the discrepancy between their large future infrastructure investment
needs and limited headroom for general government borrowing, while achieving cost
reductions through the efficiency gains resulting from the private management of operations
and private control over investment decisions. Across developing countries, private
participation in infrastructure (PPI) increased rapidly from $ 18.1 billion in 1990 to a peak of
$ 127 billion in 1997, but declined significantly in the following years down to $ 47.4 billion
in 2002, when it was back at about the 1994 level.

For many countries, exclusive dependence on foreign capital to finance infrastructure carries
risks and domestic capital markets are often an important and even necessary alternative, or
complement, to foreign infrastructure financing. Emerging market infrastructure programs
have depended heavily on foreign financing sources - at least initially. Under-developed
financial markets in many developing countries are unable to supply the volumes of long-
term domestic financing required by private infrastructure projects. However, this heavy
reliance on foreign funding has several drawbacks which can have particularly strong effects
on infrastructure investments. Many infrastructure projects derive revenues denominated
only or primarily in FILal currency. Where obligations to suppliers or providers of debt and
equity are denominated in foreign currency, the project is exposed to convertibility, transfer
and exchange rate risks. Since foreign investors are generally unwilling to bear these risks,
risks are often shifted to the government or to consumers. For instance, project tariffs and
debt are often indexed to and payable in foreign exchange by a purchasing state enterprise.
Moreover, negative movements in the exchange rate can lead to asset-liability mismatch
leading to liquidity problems for project financing. Exposure to such conditions can force
governments to bail out projects that are deemed too important to fail, such as the toll roads
in Mexico subsequent to the 1994 liquidity crisis. In addition, foreign ownership and
financing of infrastructure may be politically unacceptable. Involving FILal investors
through domestic financing for critical infrastructure can help reduce the political sensitivity
of such projects.

For these reasons, developing the access of sub-sovereigns to domestic sources of finance is
on the critical path to future development.

(iii) Financial intermediaries in infrastructure finance

For many countries, exclusive dependence on the budget for financing infrastructure is not
an option, since fiscal situations in many countries are strained. In the absence of substantial
direct budgetary financing, infrastructure developers must turn to financing through the
banking system, or financing through capital markets. Financing through bank loans is an
option, although the nature of infrastructure investments – usually long-term, high risk, and
with limited liquidity - often combine to make such investments unattractive to banks. But
the difficulty of depending on banks as a major source of financing are (i) it may be difficult
for most commercial banks to provide very long term loans, as for prudential reasons they
are advised to maintain a match between the duration of their assets and liabilities.
Commercial bank deposits generally are not of sufficiently long maturities to provide such

                                              25
financing. (ii) the large volume of loans required for such investments makes them highly
risky, and commercial banks are often unwilling to lend in such situations without guarantees
from some state entity. (iii) commercial banks are usually not able to finely price risk,
through interest rate variations.

Therefore, other financial intermediaries are required that are better equipped to take on
risks posed by such projects. Capital markets and NBFIs can play a critical role in mobilizing
resources for infrastructure finance, in allocFILating resources among infrastructure finance
programs and projects, and in mitigating the risks of private participation in infrastructure
projects. These intermediaries can accommodate the wide array of risks encountered in the
sector, including equity risk in sovereign and sub-sovereign PPI finance, public debt finance
for sovereign and sub-sovereign infrastructure program finance, and structured debt finance
for both sovereign and sub-sovereign infrastructure program finance and for PPI finance.
Capital markets act as alFILators of resources among alternative infrastructure investment
programs and projects based on their respective risk/return profile. The roles of other
intermediaries such as infrastructure private equity funds, bond underwriters and credit
rating agencies are key to this dimension. Capital markets can also provide risk mitigation
products to facilitate PPI, by providing cover to sovereign and sub-sovereign policy risks,
including political risk, convertibility risk, transfer risk and sub-sovereign breach of contract
risk.

A range of instruments can be deployed to enhance the role of capital markets and NBFIs in
financing infrastructure investments. These range from partial credit guarantee facilities to
enhance sub-sovereign bonds under the public finance model, to equity mobilization
instruments and partial risk guarantee facilities under the PPP model. These are explored in
depth in the Policy Note entitled “Making Capital Markets Work for Infrastructure
Finance”.

B.       Housing Finance15

The demand for housing finance services is undergoing profound quantitative and
qualitative changes in many countries of the world. Three different but interacting forces are
at work:

        Accelerating urbanization requires housing finance systems capable of responding to
         a strong domestic demand.
        Major technological and regulatory advances together with very significant financial
         innovations are making reforms in the financial sector and in mortgage finance both
         desirable and possible. Contractual savings reforms, the rise of new institutional
         investors such as pension funds and insurance firms and the development of capital
         markets are creating new opportunities to better manage mortgage market risks.
        New directions in public policies, including urban policies, are redefining the
         public/private sector balance in the regulation and provision of most urban services.

15
  This section draws heavily from Chiquier, Hassler, and Lea (2004), “Mortgage Securities in Emerging
Markets” and from the Bank’s website on housing finance
http://wbln0018.worldbank.org/html/FinancialSectorWeb.nsf/generaldescription/1Housing+Finance?opend
ocument.


                                                 26
        New ways financing of social housing also aim to develop more sustainable
        programs that can reach social groups at risk.

Despite its recognized economic and social importance, housing finance often remains
under-developed in emerging economies. Residential lending is typically small, poorly
accessible and depository-based. Lenders remain vulnerable to significant credit, liquidity and
interest rate risks. As a result, housing finance is relatively expensive and often rationed. The
importance of developing robust systems of housing finance is paramount as emerging
economy governments struggle to cope with population growth, rapid urbanization, and
rising expectations from a growing middle class.


(i) Financial intermediaries in housing finance

Depository institutions – such as commercial banks – are often reluctant to offer housing
loans, citing a lack of access to long-term funds. To the extent that core deposits – even if
they are short term – finance housing loans, they expose the lenders to interest rate risks and
result in pass-through of this risk to borrowers in the form of adjustable-rate mortgages.
The capital markets and NBFIs in many economies provide an attractive and potentially
large source of long-term funding for housing. Pension and insurance reform has created
large and rapidly growing pools of funds in many countries. The advent of institutional
investors has given rise to skills necessary to manage the complex risks associated with
housing finance. The creation of mortgage-related securities (bonds, pass-throughs and more
complex structured finance instruments) has provided the multiple instruments by which
housing finance providers can access these important sources of funds and better manage
and alFILate part of their risks.

There have been numerous attempts to develop mortgage securities to secure longer term
funding from capital markets and NBFIs for housing in emerging economies. The view has
been that such instruments can help lenders more efficiently mobilize domestic savings for
housing, much as they do in industrial countries. In addition, mortgage securities are pursued
to develop and diversify fixed-income markets as a supplement to government bonds for
institutional investors. Despite the strong appeal of financing housing through the capital
markets, there are significant barriers to the development of mortgage securities in emerging
markets. Their success is dependent on many factors, starting with a strong legal and
regulatory framework and liberalized financial sector, and including a developed primary
mortgage market. Perhaps not surprisingly, the experience in developing mortgage securities
in emerging markets has been mixed.

(ii) Key issues in mobilizing finance for housing

Despite numerous attempts, there have been limited successes in introducing mortgage
securities in emerging markets on a significant scale. There are two major reasons for this
result. First, the infrastructure requirements for mortgage security issuance are demanding,
time consuming and costly. There are complex legal and regulatory pre-requisites for
mortgage security issuance. It takes time and significant government support to develop the
proper legal and regulatory infrastructure. This infrastructure also adds to the cost of



                                               27
funding through securities issuance, often making it uneconomic. There are also challenging
primary market requirements. Although not inconceivable, it is highly unlikely that mortgage
securities can be successfully issued in countries with weak and under-developed primary
mortgage markets. There must be a modicum of standardization in mortgage instruments,
documents and underwriting, reasonable standards of servicing on the part of lenders and
issuers and professional standards of property appraisal. Capital market funding can provide
a strong incentive to improve primary market standards in these areas, but there can be no
substitute for a certain degree of market development preceding introduction of new
funding vehicles.

Even in countries with reasonably well-developed primary markets there has been spotty
success introducing mortgage securities. A major reason has been a lack of issuer need for
capital market funding. Lenders seeking to access the capital markets through mortgage
securities do so in order to better manage capital and risk and to lower cost and diversify
funding sources. In most circumstances, the cost of wholesale funding through mortgage
securities is higher than retail funding, at least in terms of the relative cost of the debt. If
lenders are not capital or liquidity constrained, they may view mortgage securities as
excessively costly and complex. Alternatively, some lenders confronted with serious financial
constraints and therefore strongly motivated have managed to overcome the obstacles
against the development of securitization.

In some cases, the mortgage security design has perhaps been overly complex for the
environment. Mortgage securities can be complex or simple products or structures
(mortgage bonds, agency bonds, securitization, structured finance etc.), differently stripping
and pricing the related credit and/or market risks. The use of particular instruments needs to
be in line with the standards and prerequisites of investors and the underlying legal
infrastructure, as well as the funding and residual risk exposure needs of primary lenders.
Institutional models should be adjusted to the development stage of financial and mortgage
markets. Multiple legal and regulatory challenges must to be addressed, in particular in civil
code countries.

(iii) Pre-requisites for issuing mortgage securities that can finance housing

       There must be a demonstrable market need for the type of funding offered by the
        capital markets. It is almost always the case that capital market (wholesale) funding is
        more expensive than retail (typically deposit) funding on a debt only, non-risk
        adjusted basis. Lender who are capital constrained, liquidity constrained or who are
        looking to capital markets for risk management purposes are likely to access capital
        markets.
       There must be a demonstrable investor demand for mortgage-related securities.
        Specifically there must be a class of investors with an appetite and capacity for
        securities backed by mortgages. In certain circumstances, the demand may come
        from other lenders. More likely, the demand will come from institutional investors
        such as insurance companies or pension funds. These investors will have long term
        liabilities and thus seek longer term assets to match their cash flow and investment
        needs. The task is to get these investors to fund housing through purchase of
        mortgage securities.


                                              28
         Even if there are willing issuers and investors, there are a number of infrastructure
          requirements underlying the development of mortgage capital markets. These include
          (i) an adequate legal, tax and accounting framework for securitization and secured
          bond issuance (ii) facilities for lien registration (iii) ability to enforce liens (iv) ability
          to transfer (assign) security interest and (v) protection of investors against
          bankruptcy of originator or servicer.
         There are a number of primary market pre-requisites as well. These include: (i)
          standardization of documents and underwriting practices (ii) high quality servicing
          and collection and (iii) professional standards of property appraisal.

(iv) Role of Government’s in developing mortgage securities

While many issues that affect the development of other financial intermediaries also affect
the development of housing finance, there are some aspects specific to mortgage markets
that need attention.

         Housing finance is a major form of secured or collateralized lending. The relative
          efficiency of housing finance from a primary market basis depends critically on the
          legal infrastructure supporting the security of collateral and lender access to it. Thus,
          a necessary government involvement to generate capital market funding of housing
          is creation and maintenance of a strong legal system supporting collateralized
          lending.
         Governments clearly have an enabling role to play in creating mortgage capital
          markets. Governments can and should act to remove onerous laws, taxes and
          regulations that preclude or disadvantage mortgage securities, and reflect in
          regulatory regimes the safety that mortgage securities can provide reflecting their
          collateralization. For example, stamp duties on securities registration can inhibit
          issuance. The requirement that borrowers consent to a transfer of ownership adds to
          the cost and disadvantages mortgage securitization. It is particularly important to
          create sound and thorough guidelines for the creation and bankruptcy remoteness of
          special purpose vehicles (SPVs) and mortgage bonds.

Further details of the ways in which Governments can encourage development opf
mortgage securities are discussed in Chiquier et. Al. (2004).

(v)       The Bank’s role in developing the housing finance sector

Client countries request assistance in modernizing their housing finance sector in various
ways:

         Strengthening primary mortgage markets, including resource mobilization as well as
          mortgage origination by improving the legal and regulatory framework
         Developing the primary mortgage market infrastructure including better instruments
          to manage financial risks
         Restructuring low or non-performing state-owned housing banks and specialized
          public programs
         Restructuring pension funds dedicated to housing in the process separating social
          housing subsidies from market finance


                                                   29
          Developing secondary mortgage market institutions to link housing finance to capital
           markets.

The Bank Group can provide assistance in the following ways:

                   Housing finance systems diagnoses
                   Advice on the legal and regulatory framework for financing housing and
                    strengthening the primary mortgage market
                   Advice on the design of housing finance reforms
                   Restructuring of and loan support for the financing of social housing in
                    market economies to improve its efficiency to reduce budgetary pressures
                    and achieve targeted subsidies that do not undercut the growth of market
                    based mortgage finance
                   Development of financial linkages between housing finance, capital markets,
                    and NBFIs. Alternative forms of secondary market institutions taking into
                    account their path dependency on the structure of the primary mortgage
                    market and the stage of development of bond markets

VIII. Financial intermediaries that can meet emerging needs

As discussed above, emerging long-term financing needs of countries can be met by financial
intermediaries beyond banks and DFIs. Capital markets, NBFIs such as pension funds and
insurance firms, and other intermediaries can meet specific emerging needs. These
institutions have long-term liabilities and naturally look to invest in long-term assets. The
Bank has been playing a role in the development of these intermediaries and can continue to
do so. This section focuses on two specific examples of pension funds and insurance firms
and the role that they have played in development of financial intermediation and addressing
the need of countries for long-term finance.

A. Pension Funds in Chile16

Chilean pension funds present a good example of the development of a new financial
intermediary mobilizing long-term domestic resources that have been invested – among
others - in some of the areas discussed above such as infrastructure and housing. The
pension funds controlled about $37 billion in assets (March 2002) – about 55 per cent of
GDP.

                                                  Figure 3




16
     This section is extracted from “The Chilean Pension System”, Fourth edition, May 2003, SAFP, Chile.


                                                     30
31
                                          Figure 4




The development of the pension funds in Chile has benefited several sectors of the country’s
economy. In some cases it has contributed to the growth of economic sectors and markets
which already existed, such as the capital market, infrastructure financing, and financing for
housing, whereas in other cases it has permitted the growth of markets which were virtually
non-existent prior to the reform of the pension system, such as the life insurance market.
The growth of the pension funds, which in December 2001 represented 55% of the GDP,
has meant a heavy demand for financial instruments from these investors. The future growth
expected for these resources (estimated to reach 74% of GDP by 2010) makes it likely that
their role in these areas will grow further.

Chilean pension funds have had a significant impact on the country’s capital markets. They
have also played a key role in mobilizing long-term domestic resources for investment in
areas such as housing finance. Pension funds have been key investors in the housing market
– having invested nearly 13 per cent of their assets in the mortgage backed securities.
Pension funds own 55 per cent of all mortgage backed securities issued in Chile (Table 7).
Pension funds have also invested nearly 20 per cent of their assets in the corporate sector –
in equity and debt – thereby providing a significant alternative to the banking sector for
raising such finance. Pension funds are required to carry out all their secondary market
transactions on formal markets. This has resulted in significant increases in the amounts
being traded on the exchanges – at an average rate of by approximately 31% per year during
1981-2001. This increase in volume has been accompanied by greater maturity and
transparency of these markets and has led to greater efficiency in the stock exchanges, with a
continual improvement in their information and trading systems. Pension funds have
therefore played a role in contributing to improved financial intermediation by capital
markets.




                                             32
                                           Table 7




Pension funds have also had a positive impact on the growth of the life insurance industry in
Chile – one that was incipient at the time of the pension reform. Pension funds are required
to take out policies with the Life Insurance Companies to cover their members’ risks of
disability and death. In addition, the choice to obtain annuities at retirement has assisted in
the development of the annuities market in the life insurance industry. Life insurance firms
in Chile obtain nearly three-quarters of their total premium income from products offered to
the social security system (Table 8).




                                              33
                                          Table 8




Pension funds, being the largest institutional investors in the country, make it possible to
finance large investment projects, by purchasing a wide variety of financial instruments
through the capital market. Pension funds have dis-intermediated banks to some extent by
directly meeting long-term financing needs of firms. Pension funds have also had a positive
effect on the development of the rating industry in Chile as fixed-income instruments in
which pension funds invest are required to be rated by private rating agencies. The presence
of such long-term investors has also resulted in the creation of new instruments such as
infrastructure investment funds and securitization.




                                            34
                                           Table 9




Chilean pension funds are also increasingly playing a role in financing infrastructure. Several
avenues for infrastructure investment are being used by the funds. Investing in bonds of
private companies that receive the public works concessions is one avenue. Greenfield
investment as well as investments in established infrastructure operations are being
undertaken through direct investments with benefits to both the pension funds and the
developers. Pension funds gain access to high yielding bonds, while developers gain access to
longer term funding. Pension funds are also financing infrastructure indirectly through
investments in infrastructure funds, which in turn invest in infrastructure projects.

Overall, pension funds in Chile are financial intermediaries that have been playing an active
role in mobilizing and investing long-term resources for the economy.




                                              35
                                                                Table 10




                                                                Table 12




                     B.    Insurance firms? (Rodney?)                                                                   Formatted
                     Insurance and Contractual Savings

                                                           Outliers
                     There has been little explicit work done in the World Bank on the roles of the institutional
                     investors (on both asset and liability sides of their balance sheets) in capital market and real
                      3,500
                     sector development. A number of econometric studies have been carried out but these have
                      3,000
Life Prem./ Capita




                     not been translated into policy statements. Operational involvement has been ad hoc and
                      2,500
                     largely through TA rather than lending activities (e.g. the funds management advice being
                     provided to India as part of the introduction of the new Civil Service DC arrangements). An
                      2,000
                     1,500
                     1,000
                                                                   36
                       500
                          0
                              0           10,000         20,000            30,000        40,000          50,000
                                                             GDP/ Capita
indirect attack on the issue has been made through a number of FSAP assessments as the
Insurance Methodology includes an ‘Assets’ Core Principle. However Tthese assessments
have had a prudential/ market conduct rather than a broad developmental bias. Finally, there
is an onging dialogue within the Financial Sector anchor about integrating the work of the
Contractual Savings and Insurance (CSI) and Capital Markets (CM) teams, with the annuities
markets work being the most tangible example to date.

(i)                                              Sectoral Issues

In most countries institutional investors comprise the second largest set of financial
intermediaries after the deposit takers, and in some industrial markets are larger (particularly
when measured in terms of domestic liabilities). The first exposure to the financial sector of
the working poor in particular has often involved an insurance institution such as a funeral
society, a friendly society or an industrial business life insurer (the original forms of micro-
insurance in what is now the industrial world).There appears to be a typical power curve
linkage between stage of economic growth and development of institutional investors, with
an exponent of around 1.4 (Chart 1).

                                                            Figure 5: Institutional Investor Growth - OECD


                                             6
      Ln Institutional Investment as % GDP




                                             5




                                             4
                                                                                    Korea
                                                                                                                 Norway
                                             3




                                             2




                                             1




                                             0
                                                 0        0.5        1        1.5           2            2.5     3        3.5   4

                                                                                                Ln GDP/ Capita


Source: Source: OECD Institutional Investor’s Statistical Yearbook 2003

 In most countries institutional investors comprise the second largest set of financial
intermediaries after the deposit takers, although in developing markets they have typically
been much smaller, and largely reflect non life insurer’s assets. In some advanced industrial
markets institutional investors are the largest financial sector component (particularly when
measured in terms of domestic liabilities).




                                                                                    37
The two elements of the insurance sector are non life and life. They are in fact so different
that they might be seen as different sectors17. As a key real sector risk management
instrument non life insurance is an intrinsic part of any economy and, particularly those at
and beyond the transition stage: there is a very clear power curve relationshiplinkage
between economic growth and non life density18 (Chart 1). The non life sector is typically
the 4th or 5th largest holder of financial assets in a modern economy, but risk management
considerations mandate relatively high liquidity and should (but does not always in practice)
limit the scope for riskier investment allocations 19.

In some countries intermediate entities have sprung up which purport to provide life
insurance like benefits but with higher returns (e.g. Pre Need companies in the Philippines).
These are often sold to the poorer, less educated sections of the community and are less
vigorously regulated than life insurers. The funds accumulated under these schemes typically
support the business activities of companies associated with their management vehicles, and
do not add significantly to economic development.

                                          Figure 6: Non Life Insurance Growth


                                     Elasticity of Non Life Density to GDP/ Capita

                             8

                                                           Korea
                             7

                                                                                          Norway
     Ln Premium per Capita




                             6


                             5


                             4


                             3


                             2


                             1


                             0
                                 0    2           4                6            8               10             12

                                                        Ln GDP per Capita


Source: Swiss Re 2000 Cross Country Data




17
   There are some arguments for seeing non life insurance as a form of commerce and life insurance as a
close cousin to banking, especially as convergence becomes more universal.
18
   For every 1% increase in GDP/ capita non life premiums per capita grow by around 1.3%. Non life
assets approximate non life annual premiums in most markets.
19
   Non life insurers, and the monolines in particular, have a growing indirect role on the liability side as
credit enhancers for structured instruments and as direct credit risk insurers.


                                                          38
The asset intensive mainstream life insurance sector has a more complex relationship with
the local environment, the major drivers being stage of economic development, the tax
regime and the role and management of funded pensions (Figure 7).




                                           39
                                         Figure 7: Life Insurance Growth Determinants

                                                             Outliers

                          3,500
                                                     United Kingdom
                          3,000
     Life Prem./ Capita




                          2,500
                          2,000
                                                                                       Denmark
                          1,500
                          1,000       S. Korea                         Austria                      Norway
                           500                                        HK         Iceland
                             0
                                  0              10,000     20,000         30,000          40,000       50,000
                                                               GDP/ Capita

Source: Swiss Re. 2001 cross country data

The major drivers of life sector growth are development of a middle class, the tax regime
and the role and management of funded pensions. All the countries in the lower raight hand
qauadrant of Figure 7 have generous retirement arrangements and these are either unfunded,
or handled largely through intermediaries other than insurers (although, as in Austria, they
are often de facto insurers). The impact of pensions policy is perhaps most sepectacularly
seen in Australia where life insurance and private funded pensions continue to equate to
approximately 45% of household financial assets, but where they went from parity in 1993
to private pensions entities20 being a significantly larger component by 2001.

South Korea’s life insurance industry has the characteristics of a secondary banking sector,
while the United Kingdom life insurance sector retains strong roles in both retirement
savings and mortgage funding and in the past enjoyed considerable tax advantages. If these
path dependent outliers are removed it is seen that the life insurance penetration (premium/
capita) sector has typically growsn atconsiderably faster than other institutional investors
once a minimum wealth threshhold has been attained. about twice the rate of GDP/ Capita.

In some developing countries intermediate entities have sprung up which purport to provide
life insurance like benefits (e.g. Pre Need companies in the Philippines and funeral societies
in Africa). These are often sold to the poorer, less educated sections of the community and
are less vigorously regulated than life insurers. The funds accumulated under these schemes
sometimes support the business activities of companies associated with their management
vehicles, and usually do not add significantly to economic development.



20
  Which benefit from reduced income tax on contributions and a mandated minimum employer
contribution level.


                                                               40
The introduction of supplementary pension systems in many developing and emerging
markets is likely to change historic patters, with a more rapid early build up of institutional
investment funds. The impact of pensions policy in industrial markets is less clear. In
Australia where life insurance and private funded pensions have equated to approximately
45% of household financial assets for a decade, they went from parity in 1993 to private
pensions entities21 being a significantly larger component by 2001. Regardless of institutional
form there will be an enormous build up of funds in industrial countries and these will be
seeking international investment opportunities (Figure 8).

         Figure 8 – Global build up of pension and insurance funds 2002 to 2015                         Formatted


                                     Funds Growth Sources


                 70


                 60


                 50


                 40
                                                                                   funding Increments
     $Trillion   30                                                                Retirees
                                                                                   New Members
                 20
                                                                                   Regular Growth
                 10
                                                                                   2002

                  0


                 -10
                       1      2         3         4         5         6

                                    Category Build Up


Source: ING

The tax aspect to some extent also accounts for the fact that in the OECD countries
investment companies (including mutual funds) now rival life insurers in terms of assets
under management (each controls 32% of all institutional assets). The proceeds of a life
insurance policy are typically tax free in the hands of the policyholder, who effectively
recieves the insurance company’s tax rate. Investment companies pass tax through at the
investors own marginal tax rate, although they have some influence over when the tax
liability is realized. Thus high income earners should have a preference for life products if
the pure insurance aspect is discounted. In practice life insurers usually have higher expense
rates, largely reflecting the use oif inefficient agency systems, and this can vitiate any tax
arbitrage.




21
  Which benefit from reduced income tax on contributions and a mandated minimum employer
contribution level.


                                                41
The overall trend is likely to see disintermediation, including market share transfers to life
insurers, continuinges to be a long term trend in most OECD countries, although the rate
and pattern will varyies widely according to development stage and prior path (Table 11):


Table 11: Institutional investment as a % of household financial assets:
Country     Institution                1995    2001
Hungary Life                           3.9     4.6
            Investment Co.             0.7     5.3
            Private pension            0.0     5.4
Portugal Life                          2.7     7.7
            Pension Funds              4.5     6.2
Sweden      Life                       14.5    23.1
            Investment Co.              6.7    10.6
USA         Life                       6.6     7.1
            Investment Co. (open)      5.8     9.0
            Pension                    19.7    20.0
Source: OECD Institutional Investor’s Statistical Yearbook 2003



(ii)       Asset Allocation Implications

The choice of long term savings institutions will not in the future be neutral in terms of
subsequent asset allocation. A life insurer’s main competitive advantage is that it can offer
embedded options in its products. The most common is a modest guaranteed minimum
return at the end of the policy period, a relatively benign option. The existence of embedded
options which can be triggered before a policy’s maturity date (increasingly popular in
developing markets) can create dynamic liability durations which are difficult to hedge in
even the most developed capital markets22. Despite this there has been little relationship
between capital requirements and the level of mismatching between assets and liabilities, at
least outside the English speaking world, Northern Europe and the more advanced S.E.
Asian countries (Table 2). The gradual introduction of risk based capital to other
jurisdictions will undoubtedly modify product design and almost certainly reduce holdings of
the more volatile asset classes worldwide.

Defined benefit pension funds have a different problem. They are becoming effective
increasingly liabilities of the sponsoring company and the investment policy being adopted is
effectively thus being adopted by passed through to the marginal risk/ return received by
shareholders of that company. In the absence of inflation guarantees, and given the short
term nature of profit reporting under IAS (and the impact of IAS19 in particular) there will
be an increasing imperative for the remaining DB plans to move to less volatile asset classes.

DC pension plans, which are already beginning toincreasingly dominateing institutional
investments (see comment on Australia above), particularly in less developed and emerging
markets, are thus the main likely source of capital market growth. This growth will be partly

22
     Life insurance liabilities are illiquid : no market exists – thus ALM remains a key issue.


                                                          42
reflected on both life insurance and investment company statistics in emergeing markets, to
the extent that these institutions participate in the supplementary pensions markets. Even
here there is a growing tendency to manage investment risk on behalf of plan members,
given the increasing evidence that most people are incapable of making rational choices in
light of their own situations (and are often under sales pressure in an environment where
commissions tend to be correltaed with asset risk). The current debate as to whether equity
markets tend to revert to equilibrium values is, if anything, also likely to reinforce a more risk
averse approach.

The slow emergence of annuity markets will necessitate the development of long term
capital market instruments however these will need to evidence minimum acceptable degrees
of cash flow predictability.

Table 12: Life insurer asset allocations by country - 2001

Country                 Institutional Inv’s       Life      Insurers   %          %          %         %          Formatted
                        as %GDP                   assets as % GDP      Liquids    F.I.       Equity    Other
RBC Countries
Canada                  116                       29                   5.110.6    62.465.7   19.19.4   17.610.1   Formatted
USA                     191                       41                   123.7      54.46.7    29.76     0.92.3     Formatted
Non RBC                                                                                                           Formatted
Australia               130                       41                   8.213.0    31.827.8   585.96    1.13.6
                                                                                                                  Formatted
Czech Republic          15                        8                    10.6       62.4       9.4       17.6
                                                                                                                  Formatted
Mexico                  12                        2                    0.7        86.2       5.9       7.2
                        10                        5                    28.723.6   57.366.5   10.07.7   4.02.2     Formatted
Poland
Portugal                52                        22                   8.38.4     56.05.5    7.87      28.30      Formatted

UK                      191                       97                   11.19.6    19.10      57.39.8   12.611.5   Formatted
Source: OECD Institutional Investor’s Statistical Yearbook 2003                                                   Formatted
                                                                                                                  Formatted
The relatively low equity percentages which apply to life insurers in non RBC 23 countries
                                                                                                                  Formatted
other than the UK and Australia reflect a combinations of influences. The most important
is probably the lack of development of relevant sections of the capital market. However                           Formatted

governments often also intevene in the investment strategies of institutional investors, either                   Formatted
to sustain chronic deficits or for the purposes of encouraging infrastructure development                         Formatted
and housing. For example as late as the mid 1970s New Zealand imposed a 50/30/20 rule                             Formatted
on life insurers24. The French government has recently indicated that it will require long                        Formatted
term investors to apply a minimum proportion of their assets to entrepreneurial activities.                       Formatted
                                                                                                                  Formatted
The high Australian and UK equity ratios reflect more flexible liability structures than apply
                                                                                                                  Formatted
in countries influenced by Continental contractual forms, and the use of smoothing
techniques by a well entrenched actuarial profession. These techniques are now being                              Formatted

questioned and the equity proportion in the UK has reduced precipitously since 2001. In                           Formatted
Australia a significant proportion of market risk has been transferred to policyholders in the                    Formatted
form of investment linked contracts.                                                                              Formatted
                                                                                                                  Formatted

23                                                                                                                Formatted
  Risk based capital.
24
  At least 20% of net funds increase in sovereign debt, at least 30% in sovereign and sub sovereign debt
and at least 50% in sovereign and sub sovereign debt and housing finance.


                                                          43
Much of the ‘Other’ category is typically real property, often the only long term investment
available. In some countries this also reflects the primary business interest of the
institution’s principals.

(iii)     Policy issues and implications

There is a long history of institutional investors helping to build the real economies of what
are now the industrial countries. Areas of involvement have usually involved infrastructure,
the secondary industrial and tertiary agribusiness sectors (generally post the venture capital
stage) and housing. This was typically in a more stable era when governments intervened
more actively at the micro level in the financial sector, and played the primary roles in
physical infrastructure development (see reference to New Zealand above). The question
arises as to what circumstances make such intermediation possible: even in the EU
accession countries there are strict limits on investment in non listed equity investments by
supplementary pension funds. The obvious pre conditions include strong institutional
regulation and supervision and the development of suitably liquid investment instruments
with appropriate credit enhancement (in practice this may mean the government needs to
become an effective guarantor).

The introduction of manadatory and voluntary supplementary pension systems in many
developing and emerging markets is likely to see a more rapid build up of institutional
investment funds than was seen in what are now the industrial countries. However this is
happening in a less stable environment in which efficient capital usage has become much
more important to institutional management and boards: in a market driven environment
the nature of their liabilities will increasingly drive the capital needs and investment policies
of the institutional investors.

The challenge then becomes to develop intermediate mechanisms to convert real sector
investments needed to grow economies into assets which meet the various institutions’ ALM
and risk capital requirements. The most likely candidates are various forms of securitized
and structured instruments. The World Bank Group’s key role would then be to help
develop and supporting the relevant intermediate institutions and products and the
supporting infrastrucure. Activities could include:

       1. Establishing mortgage and commercial debt packagers                                       Formatted: Bullets and Numbering
       2. Supporting the setting up of mortgage lenders insurers (possibly with partial
          sovereign capital or guarantee)
       3. Developing an infrastructure packaging capacity (including sovereign and sub
          sovereign instruments)
       4. Developing relevant product development and risk management skills within the
          institutions
       5. Helping to design and install relevant regulatory and supervissviory environments
       6. Ensuring that suitably rigorous credit rating capacities are in place
       7. Establishing appropriate legal infrastructures

(iv)      Implication for Work Program



                                               44
Institutional linkages with the real economy provide clear scope for ESW and TA with a
strong development theme. This points to cross sectorial work with PREM to develop
methodologies for assessing the current efficacy of institutional investor - real sector
linkages and the causes of any roadblocks.

From a lending perspective (aside from TA) the main opportunities arise from sectorial
restructuring and recapitalization (policy development loans) and sovereign capitalization of
professionally managed intermediaries (can policy development loans be adapted?) such as
asset aggregators and packagers and mortgage lending insurers (with a long term
privatization agenda in mind).


IX.     Constraints in the Economic, Legal and Regulatory Environment constraints
that affect both traditional and emerging needs in financial intermediation

The sustainability of providing and enhancing quality access to credit, savings and insurance
to a well defined target clientele is dependant on the creation of enabling environment and
the capacity to resolve institutional constraints. Asymmetric information and the uncertainty
embedded in economic operations determine the volume of financial intermediation, the
prices of its products and the collateral requirements.

A.     Economic and Regulatory Environment

Prudent fiscal and monetary policies that facilitate price stability and provide for a well-
aligned exchange rate are particularly important with respect to promoting long-term (LT)
credit, and LT financial intermediation. Asymmetric information is embedded in all types of
credit transactions, but the uncertainty regarding the capacity of a borrower to service his
debt grows with the loan duration. Uncertainty related to changes in policies, whether with
respect to the real or the financial sectors, reduces the willingness of for-profit creditors to
engage in LT credit transactions and when engaged, it usually results higher lending rates for
LT credit.

“Level playing field” policies are essential to ensure adequate resource allocation by for-
profit financial intermediaries. Many developing countries practiced an urban bias that
adversely impacted on lending to the agricultural and rural sectors. Such policies, besides
hampering GDP growth, generated uncertainty regarding whether such policies would ever
be removed, and if so, when. Thus, this uncertainty also adversely affects LT lending and
savings. Under such circumstances, the recommendation should be to adopt “level playing
field” policies, to eliminate over protection of what are often considered ‘priority’ sectors.
Priority sectors in many developing countries were offered direct, concessionary credit
which often crowded out for-profit intermediaries from financing such sectors. The price
of such intervention was shouldered either by other, non-subsidized, financial sector clients,
by the tax payers, or by both. Instead of supporting these subsidies, the government should
focus on providing public goods that paves the way for a more efficient, market oriented
financial intermediation by for profit financial institutions (FI).

The history of directed concessionary credit is characterized, by and large, by creating
unsustainable FIs,, repeated and substantial costly bail-outs of these FIs, and often generate

                                              45
fiscal strain. The disappointing results frequently included the finding that the relatively
well-to-do clients successfully grabbed much of the grant element embedded in the
concessionary terms of the credit, instead of being directed to the poorer target clientele, for
which it was intended. Governments that used the directed credit to ‘prop up’ the priority
sectors often shifted the fiscal burden to the financial sector but this approach has resulted
in taxing heavily and disproportionately the financial sector compared to other sectors and
generated tremendous hurdle to future growth.

The need for financial regulatory and supervisory framework is commonly accepted on
grounds that banks play a unique role compared to other sectors of the economy. Banks
operate within a sort of safety net offered by the public, with access to central banks funds in
an emergency and coverage by implicit or explicit deposit insurance. The prospective risk of
a systemic failure of the banking sector, such that failure of a single bank has devastating
impact on the rest of the country’s economy, justifies regulating and supervising of banks
and other important FIs. Experience indicates that such banking crisis causes enormous
losses to countries often exceeding sizable share of their GDP, which should be taken into
account when deciding on appropriate resource levels needed to introduce and to sustain
adequate supervision.

While justifying the regulation and the supervision of FIs is not debatable today, the issue of
how to ensure effective regulation and supervision in countries that present different levels
of economic development still constitutes a challenge. An interesting point of view reads,
“…Concentration of wealth in the hands of a few investors and the consequent lack of
development of a real market for equity considerably weaken bank capital-to-risk weighted
asset as a regulatory tool to constrain bank risk taking.25”

Accounting and auditing are important in ensuring the availability of financial information
that is needed to increase the volume of financial intermediation and reduce spreads between
deposit and lending interest rates. In many developing countries, over reliance on traditional
collateral is often explained by lack of readily available, reliable financial information that is
conveniently found in developed countries. Accounting systems that don’t adhere to GAAP
and /or international accounting standards (IAS) and where sound auditing practices don’t
exist, discourage foreign and local creditors.

B.       Law and Legal Institutions26

Legal and regulatory framework for contracts. Shortcomings in laws and inefficient
institutions prevent the formal sector from delivering credit to what otherwise would have
been considered creditworthy clients. Unlike unsecured lending, secured lending rests on the
capacity of creditors to foreclose collateral in a convenient, inexpensive and quick manner.
Problems associated with inefficient laws, regulations and institutions responsible for this
enforcement, that fail to adequately protect creditor rights, result in formal creditors denying

25
  Rojas-Suarez, L. & Weisbrod, S.R. 1997. “Safe and sound financial system.” IDB: Washington, D.C.
26
  This section draws on the short note " World Bank Financial Sector Reform: The Unfinished Legal
Agenda" prepared for the Forum by by Heywood Fleisig, Research Associate at CEAL. Before retiring from
the World Bank, Heywood Fleisig served as principal economist in the offices of the chief economists for Asia
and for Latin America, and as Economic Advisor to the Private Sector Development Department.


                                                     46
credit or offering smaller loan amounts with higher lending rates than would otherwise be
the case.

Creating a security interest requires a framework that permits both parties to the transaction
to enter into a legally enforceable agreement with collateral and related circumstances that
have economic importance. Perfection is the process by which lenders establish the priority
of their security interest in collateral27.  Substantial improvements in these areas require
usually small value of resources. However, when appropriately introduced, these
improvements can raise substantial contribution to augmenting the volume of financial
intermediation as well as growth of GDP.

In terms of sequencing, legal and regulatory reform are areas in which corrective measures
can be immediately undertaken, even if policy measures have yet to be implemented to
remove major distortions in the macroeconomy, the financial sector, or the real sector28.
The rest of this section briefly sets out some legal gaps in the advice and best practice
models. Filling these gaps would always improve projects and would sometimes mean the
difference between sustainable and non-sustainable reform. The note concludes with some
considerations about best practice in operational design.

(i)      The Bank's Advice and Operations

Improve Macroeconomic Stability

More macroeconomic stability is important for many reasons. But it will not, by itself,
address the main problems in expanding access to credit or lengthening maturities of loans.
To address these problems, most Bank borrowing member countries (BBMCs) need a legal
framework that permits more effective debt collection, particularly in the use of collateral.
Macroeconomic instability can limit longer term financing. With an equal probability of a
macroeconomic disturbance every year, the risk that a disturbance will occur increases with
the term of the loan. Consequently, risk premia and credit rationing will increase with the
term of the loan. When macroeconomic instability constrains lending, rates on longer term
loans should be greater than rates on short-term loans.

However, in many BBMCs we see the opposite. Interest rates on 3-10 year mortgages are
lower than the rates on short-term loans. The better collateral outweighs the greater
macroeconomic risk from the longer-term loan. This underscores the importance of the legal
framework for collateral. The weak legal frameworks of most BBMCs allow large holdings of
real estate to serve as collateral, but not small holdings of real estate and movable property.
The natural consequence is high interest rates, small loans, and short maturities for all
borrowers except owners of large properties, typically the rich.

Improve Bank and Financial Market Regulation


27
   Fleisig, H. and de la Peña, Nuria, 1997. in “Rural Finance: Issues, Design and Best Practices” J. yaron,
M. Benjamin and G. Piprek, World Bank, Monograph #14, ESSD, : Washington, D.C.
28
   Yaron, Benjamin, and Piprek. 1997. “Rural Finance: Issues, Design and Best Practices.” World Bank
Monograph No. 14. World Bank: Washington, D.C.


                                                     47
Improving supervision and regulation is important but in itself, it also will not increase
access to more credit or to longer-term credit. Supervision and regulation cannot
compensate for the absence of a legal framework to collect debts. Rather, supervision and
regulation must conform to the constraints presented by such a legal framework. In most
BBMCs, improved supervision and regulation should further restrict access to credit.

About 70% of US loans are secured by collateral, property that the lender can quickly seize
and sell when a debtor defaults. The remaining 30% of U.S. loans are unsecured. But those
loans are backed up by a legal system that permits lenders to seize the property of non-
paying unsecured lenders or garnish their wages . Such legal systems do not exist in most
BBMCs.

Banking systems in industrial countries depend on these legal systems for debt collection.
Transferring only their supervision and regulation systems cannot possibly have the desired
effect on the financial sectors of BBMCs.

A proper legal framework for finance -- secured transactions, company law, and bankruptcy
-- also simplifies regulation by facilitating the financing of non-deposit-taking, non-bank
financial intermediaries. A good secured transactions law permits non-bank financial
intermediaries to refinance their lending by using their credit or loan portfolios as collateral
for refinancing loans. Supervision and regulation should focus largely on deposit-taking
banks, so reducing the role of such banks in the financial sector reduces the overall
economic risk from failures in supervision and regulation. In the United States, regulated
banks supply only 40% of credit. In BBMCs, that ratio is closer to 95%.

A final important regulatory issue is detecting lending to related parties. The commercial
code and the commercial registry will specify the parties entitled to bind all businesses, not
just corporations. This provides a solid guide to identifying related parties. BBMC
commercial registration systems typically do not supply this information. However, Bank
operations only rarely address their reform.

Support Development Finance Institutions

DFIs respond to the widespread and correct perception that private lenders in BBMC
countries will not supply loans for apparently socially useful projects at terms and spreads
that would be privately profitable in comparable conditions in high-income countries. The
fundamental question in designing such an institution, though, is understanding why private
lenders in BBMCs do not make these loans.

Typically, BBMC private lenders won't make these loans because their legal system makes
inadequate provision for the collection of debts. Therefore, private lenders lend only to
people they know very well. This limits access to credit in the formal sector to all except the
rich.

However, having a state-supported bank or DFI lend or guarantee loans cannot solve this
problem. That simply transfers the risk of non-collection to the state. The same poor legal
environment will also prevent the state from collecting. Not surprisingly, DFIs that still lend



                                              48
in those circumstances have lost an enormous amount of money over the years that the
Bank has supported them.

Support Insurance

Portfolio diversification and insurance can represent alternative ways of handling risk.
Consider an island republic divided into two equal parts that are identical except for weather.
There is a 50/50 chance of rain on one side or the other side. When it rains, a crop grows;
when it doesn’t rain, output is zero. Lenders would find farmers from either side very risky.
One solution is insurance: collect fees from a common pool and pay off the losers.

However, another solution is portfolio diversification: a bank could lend to farmers on both
sides of the island and, by so diversifying, eliminate all risk of non-payment.

However, in most BBMC countries the law does not permit taking security interests in
future crops. Even if lenders could take such a security interest, portfolios of such loans
often cannot be diversified. The law may require that loans must actually be transferred.
The legal foundation of modern securitization -- securing loans with other loans -- is not
envisioned under their laws. Lenders could not be sure of the priority of their loans secured
by the portfolio because the law does not permit using a portfolio of loans as collateral.

Privatize Infrastructure

Private provision of infrastructure has been a Bank aim for years. However, how do you
finance that infrastructure? Infrastructure projects usually have three assets: real estate,
physical equipment, and accounts receivable from the sale of infrastructure services. Private
lenders in the United State routinely finance such U.S. projects by taking each of these
components as collateral for a loan.

Why not do this in BBMCs? First, often the private lender cannot take the land as collateral,
either because the land is inalienable or because the mortgage collection process is
economically ineffective. Second, the lender cannot take the equipment as collateral because
the law permits no economically effective way for filing a security interest against that
equipment or for recovering it in the event of non-payment. Third, the law often lacks even
the concept of taking accounts receivable as collateral. It provides no way of establishing
such a security interest in that property or of recovering the proceeds of accounts receivable
if the lender defaults.

In those circumstances, the private investor can only make an effectively unsecured loan to
the infrastructure project. For an unsecured loan, the legal system in BBMCs typically
provides no way to turn default into an enforceable claim against the property of the
infrastructure unit that can be enforced. Nor does the law provide an expeditious form of
bankruptcy that will permit rapid division or resale of the project assets and payment of the
creditors. Faced with these problems, private investors will demand a sovereign guarantee.
As the financier, the government remains intimately involved in the provision of
infrastructure.

Support Microfinance

                                              49
Though it is still evolving, microfinance has been broadly synonymous with unsecured
lending, either through solidarity groups or some other non-collateral mechanism. This is a
finance innovation that has played an important role.

However, the informality of the clients of these institutions usually rests on legal provisions
that discriminate against women, the young, the poor, the illiterate, and indigenous citizens.
These laws effectively force these borrowers out of the legal market. Reforming these laws
is essential for poverty alleviation. These reforms will undermine the client base of
microfinance. Viable microfinance, moreover, depends on a viable system for collateral.
First, for graduating small borrowers from unsecured loans to larger, secured loans. Second,
for securitizing microfinance loans to permit refinancing microlending activities where the
deposit base is insufficient.

Support Trade Finance

Why do industrial countries usually not need special entities to finance ordinary international
trade? For example, the Export Import Bank of the United States finances no more than
1% of US exports. BBMCs need special trade financing because their laws typically do not
permit movable property to serve effectively as collateral for loans. Even where the BBMC
has a crude system for taking such collateral, their laws often set out archaic exclusions that
forbid pledging property that does not exist or property that is not owned by the borrower.
Consequently, an exporter's raw materials could not serve as collateral because they are being
transformed into the as yet non-existent final product; the importer's imports could not
serve as collateral because the importer does not yet own them; and the law may make the
exporter's accounts receivable -- the buyer's promise to pay -- useless as collateral.
Therefore, international trade financing in BBMCs is subject to the same limits as any other
unsecured finance. Trade financing projects that don't change these laws can have no
sustained economic impact.

Support Mortgage Finance

Everybody accepts the importance of mortgage finance. What limits mortgage finance in
developing countries? First, many owners or possessors of other land-use rights do not have
title. However, their mortgage laws require filing mortgages in the title registry. For a
borrower with no title, a potential lender has no place to file.

Second, even where property is titled and registered, BBMC mortgage laws provide for
systems too expensive to use with most property; their registration systems do not properly
identify the priority of claims, and their systems of foreclosure and eviction require years to
execute. A mortgage, under these circumstances, is a much more risky instrument than it is
in an industrial country.

Securitization systems that sit on top of such a mortgage system can provide some liquidity
to bank holdings of large mortgages but cannot make the underlying "securitized" assets less
risky. Attempting to circumvent these legal problems with state-run mortgage systems leaves
the basic collection problems unresolved and, because these lenders make the loans anyway,
they fail.

                                              50
(ii)     Operational Issues

The issues described here are attracting increased and sympathetic attention in the Bank's
research and publications.

They have spread in no systematic way, though, to the Bank's lending operations. In an
informal survey early last year, no important troubled financial center had a Bank financial
sector operation addressing these issues29. This is a good indicator that these reforms are not
a high priority for the Bank's units that review such operations before they go to the Board.
A recent similar informal survey of work of the Operations Evaluation Department (OED),
revealed no systematic OED review of whether financial sector operations include such legal
reform elements or whether, when they did, the project executed those elements
successfully. That is probably a good indicator that OED reviewers do not see these
reforms as a priority. Operational support is also scattered – done in some countries and not
in others – even within the same region or country grouping – even if many countries suffer
from similar problems.

(iii)    Reform: Key Characteristics and Elements of Success30

Legal reform operations have some key characteristics that will affect success.

Private support, public opposition

CEAL’s experience in over 35 projects is that legal reform has always had the support of the
private sector -- both borrowers and lenders. However, it has rarely had the full support of
the government. The reasons for this include government ignorance, desire to keep
inefficient laws because they generate revenue, desire to keep control of state-run
registration systems, indifference to improving the operation of the private sector,
satisfaction with existing state-run lenders, and support for systems that make loans that
don't get paid. The fact that the central government is the key constraint makes this reform
an ideal point of World Bank intervention. However, it also means the TM must be vigilant.

Complicated Law

The economic and legal issues in this reform are complex -- as complex for BBMCs as they
are for industrial countries. The team of lawyers and economists has to understand this and
has to further adapt the best practices of industrial countries to the constraints of the BBMC
without sacrificing the economic impact of the reform. The lawyers need experience in
drafting commercial laws, not just using in them. The economists need to be able to work
with the lawyers, to ensure that drafting choices preserve economic objectives31. The

29
 "Should the Bank and the Fund Support the Reform of Secured Transactions?", www.ceal.org
30
 For further discussion, see "The Role of Lawyers in Legal Reform: The Case of Debtor-Creditor Laws",
www.ceal.org
31
  The draft law for Romania, for example, addressed enough complex issues that it was considered
publishable in a law journal. Nuria de la Peña and Heywood Fleisig, "Romania: Law on Security Interests


                                                   51
technology people need to be integrated with this team, so that the economist and the
lawyers understand technical options and can remove barriers to new technology when they
draft the laws. The TM needs to stay on top of these issues and make sure that the output
meets the economic needs of the country

Operational Design

In principle, the legal reform could move along step by step with different operations, which
would give the TM and the country time to digest proposals. As a practical matter, TMs
change, the Bank loses interest, and reform gets dropped. Two successful Bank operations
supported this reform with adjustment operations and set passage of law as a prior
condition32. This worked, though timetable for preparation was tight. However, that
strategy requires a determined TM who can draft tight conditionality on a few conditions
and defend that decision during management review and in discussions with the government

(iv)     Elements of Failure

Lawyers working without Economists

Lawyers working without economists will often modify draft laws in ways that undercut
economic reform. They may do this because they do not understand the link or cannot
explain it to the government or Bank management. A good reform cannot be taken off the
shelf and applied without modification.

Put the borrowing member government charge

BBMC governments will typically not push this reform forward. They will use project funds
to hire local lawyer friends who do not understand cutting edge issues in designing these
laws or the history of their reform in industrial countries. Consequently, they compromise
on key economic details. The supervision budgets of most TMs will not be sufficient to
control this.

Finance a registry with no proper legal reform

This reform is not a technical problem. It is a legal problem with a technical aspect. A new
filing archive or registry without accompanying legal reform will have no economic effect.




in Personal Property and Commentaries", 29 Review of Central and East European Law 2004 No.2, 133-
217.
32
   Based on early indicators, the Romania reform has been enormously successful. See "Secured
Transactions Reform: Early Results from Romania ", www.ceal.org.


                                                 52
VIII. Legal and regulatory constraints that affect both traditional and emerging
needs in financial intermediation

(Need input from Heywood Fleisig in this section. It currently has inputs of Jacob
Yaron).

The sustainability of providing and enhancing quality access to credit, savings and insurance
to a well defined target clientele is dependant on the creation of enabling environment and
the capacity to resolve institutional constraints. Asymmetric information and the uncertainty
embedded in economic operations determine the volume of financial intermediation, the
prices of its products and the collateral requirements.

Prudent fiscal and monetary policies that facilitate price stability and provide for a well-
aligned exchange rate are particularly important with respect to promoting long-term (LT)
credit, and LT financial intermediation. Asymmetric information is embedded in all types of
credit transactions, but the uncertainty regarding the capacity of a borrower to service his
debt grows with the loan duration. Uncertainty related to changes in policies, whether with
respect to the real or the financial sectors, reduces the willingness of for-profit creditors to
engage in LT credit transactions and when engaged, it usually results higher lending rates for
LT credit.

“Level playing field” policies are essential to ensure adequate resource alFILation by for-
profit financial intermediaries. Many developing countries practiced an urban bias that
adversely impacted on lending to the agricultural and rural sectors. Such policies, besides
hampering GDP growth, generated uncertainty regarding whether such policies would ever
be removed, and if so, when. Thus, this uncertainty also adversely affects LT lending and
savings.

Under such circumstances, the recommendation should be to adopt “level playing field”
policies, to eliminate over protection of what are often considered ‘priority’ sectors. Priority
sectors in many developing countries were offered direct, concessionary credit which often
crowded out for-profit intermediaries from financing such sectors. The price of such
intervention was shouldered either by other, non-subsidized, financial sector clients, by the
tax payers, or by both. Instead of supporting these subsidies, the government should focus
on providing public goods that paves the way for a more efficient, market oriented financial
intermediation by for profit financial institutions (FI).

The history of directed concessionary credit is characterized, by and large, by creating
unsustainable FIs,, repeated and substantial costly bail-outs of these FIs, and often generate
fiscal strain. The disappointing results frequently included the finding that the relatively
well-to-do clients successfully grabbed much of the grant element embedded in the
concessionary terms of the credit, instead of being directed to the poorer target clientele, for
which it was intended. Governments that used the directed credit to ‘prop up’ the priority
sectors often shifted the fiscal burden to the financial sector but this approach has resulted
in taxing heavily and disproportionaly the financial sector compared to other sectors and
generated tremendous hurdle to future growth.



                                              53
The need for financial regulatory and supervisory framework is commonly accepted on
grounds that banks play a unique role compared to other sectors of the economy. Banks
operate within a sort of safety net offered by the public, with access to central banks funds in
an emergency and coverage by implicit or explicit deposit insurance. The prospective risk of
a systemic failure of the banking sector, such that failure of a single bank has devastating
impact on the rest of the country’s economy, justifies regulating and supervising of banks
and other important FIs. Experience indicates that such banking crisis causes enormous
losses to countries often exceeding sizable share of their GDP, which should be taken into
account when deciding on appropriate resource levels needed to introduce and to sustain
adequate supervision.

While justifying the regulation and the supervision of FIs is not debatable today, the issue of
how to ensure effective regulation and supervision in countries that present different levels
of economic development still constitutes a challenge. An interesting point of view reads,
“…Concentration of wealth in the hands of a few investors and the consequent lack of
development of a real market for equity considerably weaken bank capital-to-risk weighted
asset as a regulatory tool to constrain bank risk taking.33”

Accounting and auditing are important in ensuring the availability of financial information
that is needed to increase the volume of financial intermediation and reduce spreads between
deposit and lending interest rates. In many developing countries, over reliance on traditional
collateral is often explained by lack of readily available, reliable financial information that is
conveniently found in developed countries. Accounting systems that don’t adhere to GAAP
and /or international accounting standards (IAS) and where sound auditing practices don’t
exist, discourage foreign and FILal creditors.

Legal and regulatory framework for contracts. Shortcomings in laws and inefficient
institutions prevent the formal sector from delivering credit to what otherwise would have
been considered creditworthy clients. Unlike unsecured lending, secured lending rests on the
capacity of creditors to foreclose collateral in a convenient, inexpensive and quick manner.
Problems associated with inefficient laws, regulations and institutions responsible for this
enforcement, that fail to adequately protect creditor rights, result in formal creditors denying
credit or offering smaller loan amounts with higher lending rates than would otherwise be
the case.

Creating a security interest requires a framework that permits both parties to the transaction
to enter into a legally enforceable agreement with collateral and related circumstances that
have economic importance. Perfection is the process by which lenders establish the priority
of their security interest in collateral34.  Substantial improvements in these areas require
usually small value of resources. However, when appropriately introduced, these
improvements can raise substantial contribution to augmenting the volume of financial
intermediation as well as growth of GDP.



33
  Rojas-Suarez, L. & Weisbrod, S.R. 1997. “Safe and sound financial system.” IDB: Washington, D.C.
34
  Fleisig, H. 1997. in “Rural Finance: Issues, Design and Best Practices” J. yaron, M. Benjamin and G.
Piprek, World Bank, Monograph #14, ESSD, : Washington, D.C.


                                                   54
In terms of sequencing, legal and regulatory reform are areas in which corrective measures
can be immediately undertaken, even if policy measures have yet to be implemented to
remove major distortions in the macroeconomy, the financial sector, or the real goods
sectors35.

CONCLUSION? Access to finance can be enhanced substantially by shifting
resources that are often used for subsidizing concessionary credit to ultimate clients
to providing instead private goods that can reduce the intermediation costs of for
profit FIs. This approach including support for pilot innovations, particularly such
innovations that were successfully implemented in other, similar socio-economic and
cultural environments could contribute substantially to the transformation of many
that are perceived by for profit intermediaries as non creditworthy clients to credit
worthy ones.

X.      Getting FSD back on the overall Bank agenda – a case study of Indonesia

The group was also assigned the task of discussing issues related to scaling up financial
sector lending. This is obviously a highly country-specific issue and depends on the Bank’s
strategy for each country. This would also depend on the degree of development of the
country under discussion – with different opportunities for the Bank in different countries.
This said, the note has outlined various issue above and discussed opportunities for Bank
activities in each area – and many of these could have general applicability.

In the group’s view, an important generic issue prior to addressing the issue of scaling up
lending should probably be – how to get financial sector development work back on the
Bank’s agenda in many countries. For many middle income countries, . Tthis is especially
relevant when working in dealing with nnon-crisis situationscountries. Lending may follow a
substantive engagement on a wide variety of financial sector issues. Some issues that may be
generally applicable are raised here for stimulating discussion.

“At its best, finance works quietly in the background; but when things go wrong, financial
sector failures are painfully visible”36.

This quotation has direct impacts for Bank staff in the financial sector area. Financial sector
lending tends to be high during crises. Once they are past – and the financial sector works
“quietly in the background” - FS staff all over the Bank face substantial budgetary pressures
as the Bank moves from a crisis management agenda to a poverty-focused development
agenda. There is a clear link with the Government’s agenda as well. In many instances,
governments also prefer to move on to other agendas as soon as a crisis is past. In practice,
even if the root causes of the crisis have not necessarily been fully addressed, once the
immediacy of a crisis is past, it is difficult to convince either the Bank (i.e. the CMU) or the
Government – to focus on the financial sector agenda.



35
   Yaron, Benjamin, and Piprek. 1997. “Rural Finance: Issues, Design and Best Practices.” World Bank
Monograph No. 14. World Bank: Washington, D.C.
36
   Foreword by Nick Stern in Finance for Growth: Policy Choices in a Volatile World.


                                                  55
One way to re-engage both the Government and the CMU is being tried out with some
success in Indonesia. The box at the end of this section presents a brief case study. The main
lessons from this case study are:

(i) There should be substantial focus on and input to the CAS. Active discussions during the
CAS preparation process probably do just as much to focus minds on the FSD agenda as the
actual document itself.

(ii) FSD work should be tied in with other country priorities and sectors. FSD should be
relevant as a partner across sectors and not just on a stand-alone basis. Tying up reform of
financial sector to the need to mobilize domestic resources for various purposes – SMEs,
housing, infrastructure finance – is likely to have more traction than using the rationale of
having a more efficient financial sector. Tying up the need to reform NBFIs to the need to
reduce overall financial sector vulnerability and creating a diversified financial sector is likely
to have more traction than arguing that a particular sub0sector needs strengthening because
it is weak. It is difficult to get CMU (and often, Government) attention unless the financial
sector agenda links to something that the is of interest in a non-crisis environment –
poverty reduction or growth.

(iii) Perseverance is important. In a non-crisis environment, financial sector reform will, of
necessity be slow. So is reform in all other sectors.

(iv) Once an active engagement of the CMU has been obtained and FSD has been put back
on the overall agenda, lending options can be considered.




                                                56
                                                   Box
                           Getting FSD back on the agenda: The case of Indonesia
 Background
      From 1997 crisis to end FY 2003, FSD work focused almost exclusively on banking sector -
         appropriate in light of crisis
      Much of FSD work funded by SFO/Center and regional resource allocation was small
      However, OED reports largely critical of Bank FS involvement leading to some strains with CMU.
         CMU interest in FSD work declined gradually as country priorities evolved. There were also differing
         sectoral and CMU viewpoints on what priorities should be. As usual, each side was right to some
         degree
         Adverse ahead
X.  The wayimpact on FSD budgets. Especially as SFO funding stopped and regional allocation was
         needed. Implied competition for FSD with other regional priorities
      A new approach was needed to revitalize FSD work in Indonesia
 A new approach
      New CAS presented to Board in FY04. This was an opportunity for refocusing FSD agenda. FSD
         work integrated with CAS priorities. Substantial effort to ensure that CAS laid appropriate emphasis
         on FSD work. This helped obtain CMU buy-in at early stage for FSD work
      What was the new focus? Strategically, move from crisis management focus to sector development
         focus.
      Operationally, Banks are 80% of Indonesia’s financial sector. Hence, policy work on banks will
         continue. But need to tie in Bank’s FSD work with other sectoral initiatives eg: INFRA (infrastructure
         finance); PREM (decentralization and sub-national finance, poverty and access to finance); RURAL
         (micro-credit, rural finance) etc. Clear recognition that developmental opportunities lie in NBFIs,
         capital markets, and linkages to other sectoral priorities. The Bank has been absent here for several
         years
      Focus FSD work on developing a diversified financial sector that can support Indonesia’s growth and
         improve access to financial services going forward
 Rationale for new approach (examples)
      Government debt markets and debt management strategy essential as Indonesia tries to finance budget
         deficit from domestic markets (PREM link). Indonesia had zero domestic public debt – and so no
         public bond market - before crisis.
      Equity/corporate bond markets essential for private sector-led growth (PSD link). Market
         infrastructure and regulatory framework need upgrading
      Institutional investors – pension & mutual funds, insurance firms etc. – needed to mobilize long-term
         domestic resources for, among other uses, infrastructure finance (INFRA link). Pension funds and
         insurance sector need restructuring and reforms
      Decentralization implies sub-national governments are thinking of accessing market
         (PREM/Decentralization link). At present sub-nationals not allowed to borrow, but situation could
         change. Major CAS emphasis on Bank lending/policy advice to local governments. Opportunity for
         FSD policy work and design of innovative financial instruments/institutions
      Simple arguments. However, tying in directly with rest of country priorities key to getting CMU
         attention
 Results
      Still very much work-in progress. There is clearly CMU interest in FSD work. FSD opinions and
         inputs are actively sought. FSD is “relevant” in the broader scheme of things in the CMU.
      Client interest in FSD work also higher
      Budgetary situation improving (gradually). Capital market work being funded. ESW on NBFIs funded.
         Banking sector policy dialog ongoing with some early and significant successes.
      Close dialog with colleagues from other sectors. FSD contribution to INFRA: country ESW & regional
          study. Working with team on microfinance project. Access to finance issues being addressed in ongoing poverty
          work. Collaboration on remittance issues with SD.




                                                        57
XI.     Conclusion

The working group was asked to examine the issue of how the Bank can assist in                      Formatted
best mobilizing financial resources for long-term funding needs of clients. The group
focused on two ways in which this objective could be met. First, the group reviewed the
Bank’s past experience with financial intermediary lending (FIL) as a mechanism to provide
clients with long-term external resources. In doing this, the group examined OED’ review of
past Bank FILs as well as a case study of an FIL that has had a positive impact. Second, the
group examined emerging needs of clients and how long-term domestic resources could be
mobilized to meet these needs. In the latter, the approach taken was on development of              Formatted
institutional investors such as pension funds and insurance firms.

The Bank’s past experience with past experience with using FILs to improve access                   Formatted
to term credit has not been very successful. OED’s review finds that outcomes of the                Formatted
loans as well as adherence to Bank guidelines have been poor. Across all FILs, better
outcomes were found to be associated with stable macroeconomic conditions, stronger
financial sectors, including satisfactory competition policies and good legal and regulatory
regimes governing financial institutions, mostly market determined interest rates, few
distortionary credit and tax policies, and limited state ownership of financial institutions. The
case study of an FIL in Zambia that has had a positive impact further stresses the
importance of several findings of the OED review. It emphasizes that sound design and
strong focus on implementation issues are key to “good” FILs. From these reviews and
experiences, the message that seems to emerge is that simply providing clients with long-
term resources as a strategy to mobilize such funding has not worked.

More fundamental systemic issues that can strengthen financial sectors more broadly
so that they can both generate domestic term resources and more effectively use
externally provided resources such as through FILs need to be looked at. Beyond FIL-
related lending, the Bank has been involved in supporting financial sector reforms aimed at
improving overall financial intermediation in many countries. OED’s review of these
activities shows that while financial intermediation has improved in countries where the
Bank has been involved, the improvements in measures of financial sector depth and access
to credit have been relatively modest. Macroeconomic factors such as high inflation and
crowding out of private access to credit by the government are some of the reasons for this
modest achievement. However, evidence suggests that institutional and environmental
factors such as collateral laws, creditors’ rights, strength of judicial system and the enabling
environment for private investment or the investment climate may also play critical roles.
These low levels of financial intermediation point to a need for the Bank to work with client
countries to continue to identify and remove constraints to enhancing the role of the
financial sector in mobilizing resources, channeling them to productive investments, and
managing risks related to these roles. In addition more work may be required institutional
level: the financial institutions’ capacity to provide resources and manage risks. The Bank
needs to focus its future assistance in these areas so that the necessary institutions for
successful financial intermediation can be put in place.

Legal issues present particularly severe constraints and can prevent formal financial
institutions from delivering credit to what otherwise would have been considered
creditworthy clients. Unlike unsecured lending, secured lending rests on the capacity of

                                               58
creditors to foreclose collateral in a convenient, inexpensive and quick manner. Problems
associated with inefficient laws, regulations and institutions responsible for this enforcement,
that fail to adequately protect creditor rights, result in formal creditors denying credit or
offering smaller loan amounts with higher lending rates than would otherwise be the case.
Substantial improvements in these areas require usually small value of resources. However,
when appropriately introduced, these improvements can contribute substantially to
augmenting the volume of financial intermediation as well as growth.

There is also a need for the Bank to be responsive to the question of what its
financial intermediation activities should be, given the emerging challenges faced by
its clients. FILs channeled through DFIs and/or banks are the traditional way in which the
Bank has addressed financial intermediation. Several countries (especially middle income
countries) now recognize that the banking system may not necessarily be appropriate to
finance some emerging needs – such as those of infrastructure, housing, and financing sub-
national governments. Capital markets and non-bank financial institutions and institutional
investors such as pension funds and insurance firms may be more relevant financial
intermediaries than banks to meet long-term financing needs. In this context, therefore, the
Bank needs to broaden its view of financial intermediation activities and enhance support for
the development of these sources of long-term funding. International experience shows that
pension funds and insurance firms have played major beneficial roles in financial
intermediation aimed at long-term domestic resource mobilization.

Finally, the group addressed the broader issue of getting financial sector work back
on the overall Bank agenda – a challenge being faced especially in many middle
income countries and those that are not in a crisis situation. In many countries,
financial sector lending tends to be high during crises. Once they are past FS staff all over
the Bank face substantial budgetary pressures as the Bank moves from a crisis management
agenda to a poverty-focused development agenda. A case study of Indonesia – which has
had some recent success in this area - provides the following main messages. There should
be substantial focus on and input to the CAS – since active discussions during the CAS
preparation process probably do just as much to focus minds on the FSD agenda as the
actual document itself. FSD work should be tied in with other country and sectoral
priorities. FSD should be seen as a relevant partner across sectors and not just on a stand-
alone basis – especially in addressing emerging needs such as infrastructure finance, housing,
SME development, and microfinance that are core to the poverty reduction /growth agenda.




                                              59
                                                 Annex 1                                                 Formatted
                   Summary of Bank experience with Municipal FILs and Microfinance FILs

I.                  Municipal FILs

As decentralization gains ground in many countries, providing access to long-term funds for
municipalities and, more broadly, sub-national governments is being increasingly stressed by
many governments. A recent internal Bank report on enhancing support to middle income
countries recommends making greater use of lending for infrastructure through FIL to sub-
national level governments (mainly municipalities). Historically, the Bank – largely through
its Urban Sector Operations - has provided lines of credit that could be accessed by
municipalities. This section reviews the lessons of this experience, based on two sources (i)
an ongoing OED study of World Bank supported municipal LOCs and (ii) a review of the
performance of Municipal Development Funds (MDFs) carried out under the World Bank
Report “Building Local Credit Systems” (April 2000).

A.                  OED Review

During the FY 1993-03 period, out of a total number of 169 regular FILs, 34 projects (20
per cent) included a municipal FIL component, which represents 20% of the FIL-
commitments of all regular FILs. The municipal FILs were mostly developed within the
Urban Development Sector of the World Bank (22 projects, 65%)37 and covered a multitude
of sectors, which can be generally labeled as “urban infrastructure”. Only two closed projects
had a sectoral focus, specializing either on Water Supply or Solid Waste. The following
analysis is mainly based on the outcomes and findings of the 13 closed projects, but includes
information from the remaining open projects where available.

                                                 Figure 9

                              Annual Appraisal of municipal LOCs
                                           FY93-03

                   1000                                          8
     million USD




                    800                                          6         FIL commitment
                    600
                                                                 4         Number of LOC
                    400
                    200                                          2
                      0                                          0
                          93 94 95 96 97 98 99 00 01 02 03
                                        Year




37
  The other main WB sectors were: Water (5 projects), Environment (3 projects), Transport (1 project),
Social (1 project), Rural (1 project), Finance (1 project)
Main Findings

        The focus of the municipal FILs was mostly on mobilizing new resources to increase             Formatted: Bullets and Numbering
         much needed investments in infrastructure and on improving the efficiency of the
         municipalities in delivering services. Additionally, most projects also addressed
         smaller objectives such as increasing the institutional capacity of the PFI, advocating
         intergovernmental reforms, improving the environment and attracting private
         investment. Over 60% of the closed projects had a significant grant elements, and
         the average grace period for the on-lend funds was around 3 years.
        Over 60% of the projects in the sample of closed projects channeled the WB funds
         through a financial intermediary38. The one financial intermediary chosen was either
         an autonomous Municipal Development Fund or a public Financial Institution who
         specialized in the provision of resources to municipalities and public enterprises. The
         decision to include only one financial institution in the project was frequently due to
         the lack of interest of commercial banks in municipal finance and the need to include
         subsidies in view of the fragile financial conditions of the municipalities.
        The outcome ratings for municipal FILs components compare favorably with the
         outcome of all regular closed FILs (see Table 13). The ratings are mostly based on
         the positive real sector outcome of the municipal FILs.

         Table 13: Outcome Ratings of municipal FILs compared to Regular FILs
         Number of rated No. (%) of projects No (%) of projects No (%) of projects
         projects          with   Satisfactory with    Substantial with           likely
                           outcomes            IDI                 sustainability
         51 regular FILs   24 (47%)            20 (39%)            31 (61%)
         13 municipal FILs 9 (69%)             4 (30%)             7 (54%)

        Only a limited number of projects achieved all or most of their stated objectives (see         Formatted: Bullets and Numbering
         Figure 10. While mobilizing resources has mostly been achieved, only limited results
         were reported in the remaining fields. Particularly improving efficiency in resource
         management has been difficult to achieve. In some cases, municipalities have been
         reluctant to borrow for technical assistance. In others, suggested reforms and
         improvements were not implemented at all or only half-heartedly. Improved cost
         recovery, albeit discussed or aimed for in the majority of appraisal documents, was
         frequently not achieved.




38
  The remaining projects channeled funds either directly from the Government to the municipalities or
used a non-autonomous Municipal Development Fund to on-lend the funds.


                                                   61
                                     Figure 10: Achievement of Objectives
                                        (in number of municipal LOCs)

         14    12           12
         12
         10         8
                                                      7            7
                                                                                               Objective at PAD
          8                               6
                                     5                                                         achieved
          6                                                            4
                                 3                            3                 3              partly achieved
          4                                   2 2         2                2
          2             1                                                           1
                                                                                        0
          0
              Resource   Impr.           intergov.     FIN        Environ.     Private
                mob.   Efficiency        Reforms     reforms       Impr.       Sector



        Overall cancellation rates for municipal FILs (50% of the committed amounts were                         Formatted: Bullets and Numbering
         cancelled compared to 54% for regular FILs) appear to be in line with the outcomes
         for the total set of regular FILs. However, excluding two dominating projects in
         Mexico that were both adversely affected by the macroeconomic shock of 1995, the
         remaining sample of closed municipal FILs had a disbursement rate of 93%, high
         even in comparison with Bank average (78%). This high disbursement rate is also
         reflected in the good outcome rating of the municipal FILs.
        This comparatively encouraging outcome might not be sustainable. Low ratings for
         sustainability and modest institutional development combined with difficulties in
         cost recovery and fiscal decentralization suggests that the overall outcomes will be
         less positive on the long run. Additionally, overall disbursement rates for the open
         sample of municipal FILs fell to an average of 45%, with 71% of the projects closing
         this fiscal year or in FY 2005.
        Only limited quantitative information on the financial situation of the PFIs or the
         Municipal Funds is available at appraisal or completion.39 Additionally, none of the
         projects complied with the requirement to compute the subsidy dependence of the
         PFIs, albeit significant amounts of subsidies being channeled through these public
         institutions. Information on lending interest rates is mostly provided in appraisal
         documents, but not during supervision and competition. The foreign exchange risk is
         also covered insufficiently. These shortcomings frequently hinder an assessment of
         the impact of the FIL on the financial viability of the PFI.
        Information on repayment rates were provided in 61% of ICRs, with only two out of
         these 8 projects suffering from substantial shortcomings in collection rates.
         However, this information has to be treated with caution since the grace periods of
         on average 3 years and the frequently high percentage of grant elements might have
         positively influenced this outcome.


39
   4 out of 7 projects reported on the loan collection rates at appraisal, but only three at completion. Two
projects discussed adequacy of loan provisioning at appraisal and two at completion. Traces of audited
financial statements are visible in 4 PADs, but none in completion reports.


                                                      62
B.       MDF Performance Review – 2000

The MDF performance review covered 10 MDFs across all developing country Regions.
The review highlighted significant problems with MDF performance across Regions:

        Erratic repayment record: loan non-performance ranged from 0% to 80%, averaging            Formatted: Bullets and Numbering
         23% across the ten MDFs under review.
        Tendency to protect debt repayment through explicit or implicit central government
         guarantees, translating into contingent liabilities for the state budget
        No significant penalties for delay in debt service payment in many systems:
         municipalities in default frequently continue to receive grants fro the central
         government and new loans from the MDF.
        Government ownership of MDF tends to exacerbate municipal credit risk. This
         manifests itself in unwillingness to pay (moral hazard)
        Bundling of loans and subsidiy funds often squeezes out commercial lenders,
         retarding the emergence of sub-sovereign debt markets
        Below-market access to sheltered resources for loanable funds. Forced sale of MDF
         bonds to State-owned institutions in several cases.
        In all cases except one, no links with competitive capital markets sources.

     Lessons learned

        Establishing a sound intergovernmental finance system with appropriate incentives is       Formatted: Bullets and Numbering
         critical. Increasing the capacity of municipalities to borrow for investment has to be
         embedded in a greater financial decentralization to ensure long-term sustainability of
         the municipalities.
        Cost recovery on the FILal level is frequently difficult to achieve. Not only in there a
         lack of political commitment, but poorer and smaller communities often face
         difficulties increasing taxes or utility charges. In the absence of grant elements or
         intergovernmental transfers, these shortcomings will limit the municipalities’ long-
         term capacity to borrow and service their debt.
        Evaluation and monitoring systems have to improve to raise efficiency of resource
         management and to provide better information on outcomes of investments.
        Overall, achieving more efficient resource management on the municipal level is a
         time-consuming process. Nevertheless, managerial, technical and financial should be
         provided within the loans.
        MDFs contribute to moral hazard on the municipal credit market and tend to retard
         sub-sovereign debt market development, both through below-market pricing of their
         loans and through access to sheltered resources
        Do note create new State-owned MDFs. Privatize those in existence, and require
         them to operate on a level playing field with other private financial intermediaries
         and capital markets




                                               63
II.        Microfinance LOC

Sixty nine microfinance lines of credit (MLOC) approved during 1993-2002 were reviewed,
including 42 ordinary microfinance lines of credit (OMLOC) and 27 revolving funds (RLF),
amounting to a total of $1,405.4 million40, an average annual commitment of about $140
million that oscillated between $20 and $328 million during the reported period of FY 1993-
2002. The number of MLOC projects increased by about 46% in the FY 1998-2002 period
over the FY 1992-1997 period, while the total MLOC commitments increased by only 30%
for the same period, indicating a significant reduction in the average commitment size in the
latter period. Also notable was the five-fold increase in the amount of commitment of RLF
projects in the second half of the reported period while the amount of OMLOC
commitments declined. For the 3 years at the start of the reported period, FY 1993-95, the
average MLOC commitments accounted for less than 5% of total Bank lines of credit
(TLOC) commitments, but in the last 3 years, FY 2000-2002, the average MLOC
commitment share increased to about 35% of TLOC commitments. The substantial surge in
the share of MLOC commitments of TLOC commitments from less than 5% to about 35%
in the FY2000-2002 over FY 1993-1995 is explained by two factors. The first is that the
Bank has increasingly underscored poverty reduction as its primary goal and MLOCs were
increasingly considered by many as efficient, cost-effective instruments in fighting poverty.
The second is the widely spread information disseminated among donors, Governments
PFIs, NGOs and target clientele regarding the successful outcomes of salient microfinance
institutions (MFIs) in pursuing extended outreach and self sustainability.

The cancelled project amounts were about 38% of closed MLOC project commitments and
about 9% percent of closed MLOC projects approved. These percentages are below the
exceptionally high rate of cancellations found in RLOC projects where 46% of RLOC
commitments were cancelled.

                  Table 14: WB Projects with MF Component Commitments

                                                               A                 B                 C = B/A
                                                               Total          Microfinance         Microfinance
                                                  Number       World     Bank Component            Component as a
                                                  of           Commitment Commitment               %    of    Total
Description                                       Projects     (in millions) (in millions)         Commitment
MLOC Projects covered in the Study                69           3,362.8           1,405.4           41.8%
     Active and Post FY97 Projects                48           2,443.3           836.9             34.3%
     Closed and Pre-FY98 Projects                 21           919.5             568.5             61.8%

MLOCs were affiliated with all sector Boards. The majority of the OMLOC projects were
over sighted by the rural and social sector Boards, accounting for two thirds of the number
of projects (28) and about 54% of total commitments. The financial sector Board provided

40
   The total number and commitment amounts of MFIL projects reviewed in this study differ somewhat from the
statistics used in the related study of Bank RFILs. That study cites 67 MFIL projects with a total commitment of
$1,222.4 million after cancellations. Part of the difference is that the MFIL study used the total MF component amount
of commitment while the RFIL study used only the FIL.


                                                         64
over sight to 7, or 17% of the total OMLOC projects that accounted for 41% of the
OMLOC commitments.

A different distribution pattern was found with respect to RLF projects where no project
was affiliated with the financial sector Board. Almost all RLF projects were over sighted by
the rural, urban and social sector Boards, accounting for 85% of total RLF projects
combined and about 99% of the RLF commitments combined. Data on the sectoral and
regional distribution of the MLOC projects and related commitments are presented in the
following tables.

                    Table 15: Sectoral Distribution of MLOC Projects

              OMLOC                                 RLF
Sector
              # of proj    $ comm     % comm.       # of proj   $ comm.     % comm
Energy        2            7.1        0.7%
Environ       1            8.6        0.9%          1           1.5         0.4%
Financial     7            405        40.6%
Health                                              1           1.9         0.5%
Public                                              2           0.4         0.1%
Private       4            36.2       3.6%
Rural/Ag      18           462.9      46.5%         14          171.6       42.0%
Social        10           76.7       7.7%          7           98.8        24.2%
Urban                                               2           134.7       32.9%
Total         42           996.5      100.0%        27          408.9       100.0%



The completed MLOC projects achieved a much higher satisfactory rating compared to the
RLOC projects and also a higher satisfactory rating than that achieved by all other Bank
investment lending. Completed MLOC projects achieved satisfactory rating of 75% percent
of the MLOC commitments and 80% percent of MLOC projects. In contrast, less than
50% of RLOC commitments and less than 60% of RLOC projects were rated satisfactory,
while more than 70% satisfactory rating was achieved by other Bank investment (non LOC)
lending operations.

Main findings

        Data on the financial performance of Participating Financial Institutions (PFIs) and    Formatted: Bullets and Numbering
         the Project Units (PUs) responsible for project implementation indicate a widespread
         culture of non-compliance with the essential reporting requirements spelled out in
         OD 8.30 (1992) and later in OP 8.30 (1998).
        The very nature of MLOC projects, regardless of the Sector Board assigned to
         ensure the MLOC’s quality, requires focus on the financial performance of the
         MLOCs. Even those projects or components that do not aim at establishing
         sustainable financial institutions should have set quantifiable key performance
         indicators (KPI) related to loan collection, arrears and subsidy dependence, but such
         data was rarely present.



                                               65
      When MLOCs were designed with a primary objective to improve the performance
       of the PFIs with respect to resource allocation, profitability, loan collection,
       sustainable lending interest rates and adequate spreads, the data essential to evaluate
       such performance were often incomplete and of low quality.
      Many Bank MLOC projects do not adhere to all sound practices in microfinance.
      The quality and extent of reporting on key performance indicators essential for the
       appropriate design, monitoring and evaluation of MLOC projects is inadequate and
       falls behind acceptable standards.
      There is no evidence that MLOC projects that reported better on their performance
       achieved better results than those with inferior reporting and that MLOCs affiliated
       with the Financial sector Board performed better than MLOC over seen.

Lessons Learned

      The strange and surprising combination of the almost invariably satisfactory ratings      Formatted: Bullets and Numbering
       of MLOC projects on the one hand, and the absence of essential financial reporting
       on the other, raises doubts regarding the validity and integrity of the evaluation
       criteria used in assessing project performance. In many instances, it is impossible to
       follow the logic that resulted in evaluating the vast majority of the completed
       MLOCs projects as satisfactory when the essential financial data needed for such
       evaluation do not exist, despite the explicit call of OP 8.30 for reviewing and
       analyzing such data. Hence, revisiting the criteria and methods used in evaluating
       MLOC projects’ performance is highly warranted.
      Over the recent years pertinent research and experience gained in microfinance
       operations worldwide induced donors to reach a consensus regarding the substance
       of sound practice in MLOC lending. This consensus has served to guide staff on
       how to design, monitor and evaluate the performance of MLOC projects. The
       updating of OP 8.30 and BP 8.30, now under preparation, could substantially benefit
       from relying heavily on the reporting and performance requirements spelled out in
       various donor documents on sound practice in microfinance operations.
      To ensure that future design and implementation of MLOC projects are free of
       many of the serious deficiencies in reporting on financial performance found in this
       study, it would be necessary to clarify and strengthen the responsibilities and
       accountabilities associated with approving MLOC projects, thereby underscoring the
       need to adhere to principles and reporting requirements spelled out by OP 8.30.
       MLOC projects should report in the BDs on a minimum set of meaningful data
       related to the financial and outreach performance of the PFIs. The reporting should
       follow the present OP 8.30 requirements that in many instances were not honored.
       Assigning a senior microfinance specialist in each region to ensure that all regional
       MLOCs, irrespective of the Sector Board that provides the oversight, actually
       comply with the OP 8.30 and BP 8.30 requirements is essential if substantial
       improvement in the quality of MLOCs is pursued.
      The PSRs of MLOCs seldom provided a reliable and meaningful picture of the
       performance of the MLOCs and the related PFIs. Introducing an attachment to the
       PSRs designed to succinctly capture the essential information related to the MLOC’s
       financial and outreach KPIs could prove instrumental in monitoring the PFI’s



                                             66
        performance and eventually assist in improving the evaluation of completed MLOC
        projects.
       The review found some well-designed and monitored MLOC projects, but more that
        were deficient in both design and monitoring during implementation. The quality of
        design and monitoring appears to be primarily dependent upon the diligence of the
        task manager and possibly his/her immediate supervisor and much less due to
        systematically adhering to a minimum set of uniform design and monitoring
        standards used by all staff involved in promoting and implementing MLOC projects.
        Substantial improvements in design and implementation of MLOCs can be achieved
        just by mere adherence to guidance provided by OP 8.30 and BP 8.30, particularly
        with respect to eligibility criteria for PFIs and reporting requirements on financial
        performance and outreach.
       In addition, providing staff with clear recommendations regarding the design and
        reporting on financial aspects of MLOC projects that are not aimed at establishing a
        sustainable FI or program, presently not included in BP 8.30, could contribute
        substantially to improving the quality of the design and the implementation of these
        MLOCs. In light of the frequent absence of financial data in BDs related to MLOC
        lending operations, enriching the BP 8.30 along the above recommendation is
        essential.
       There is a need to enhance the role of TA in the design and implementation of
        MLOC projects. Microfinance is a relatively new area, whereby pertinent knowledge
        is consistently updated. However, a main deficiency of the TA provided is that it
        highlights inputs only and rarely elaborates on the outputs of the TA rendered in the
        reported period.
       Revolving funds had a fivefold commitment increase in the FY 1998-2002 period
        over the FY 1993-1997 period, and over recent years have accounted for a larger
        share of total MLOC commitments and projects. RLFs constitute a relatively new
        line of Bank operations and both deserve and require following a minimum set of
        reporting that at least would gather information on collection, subsidy dependence,
        lending interest rate, and outreach. No such data were found for the RLF reviewed.


Annex 1
Question: Jacob, does this fit in?
Assessment of DFI Performance

Jacob Yaron

Note written for the
World Bank Financial Forum
September 22, 2004

Abstract:

This note attempts to shift the emphasis from debating on whether state-owned
development finance institutions (DFIs) have a right to exist, given their relatively dismal
performance in the past, and instead focuses on developing and implementing an assessment


                                             67
framework aimed at evaluating the cost and subsidies related to the “products” delivered by
the DFI. The note further suggests an evaluation and monitoring methodology that is based
on two primary assessment criteria: outreach to a well defined target clientele and the
subsidy dependence of the DFI concerned. In view of the renewed public and client
countries’ interest in augmenting DFI operations, this approach could contribute to a
healthy public debate regarding the social desirability of the DFIs operations and the support
they benefit from, while relying on tools that quantify the costs and subsidies consumed in
the delivery of each DFI “product”. This approach also requires that decision makers,
whether states or donors that financially support DFIs, make explicit their “development” or
“poverty reduction” priorities, specify the target clientele and quantify the price they are
willing to pay for and subsidize the DFIs’ for each type of “product” delivered. Such
specific “products” can constitute a loan to an household below the poverty line, or a loan to
a small and medium enterprise (SME) in an amount not exceeding 30 times the GDP per
capita, whereby different levels of social desirability are assigned to each “product” and
eventually builds up to a hybrid output index of the DFI.

Background

State-owned DFIs remain a hallmark of traditional, supply-led government attempts over the
last sixty years to promote development finance in pursuit of boosting production,
increasing incomes of priority sectors and/or underprivileged segments of the population
and fighting poverty. At a more recent stage, DFI operations were also justified on grounds
of compensating target clientele for the absence of level playing field policies (e.g. directed
concessionary credit to farmers as a compensatory device for urban bias). The performance
of most of these DFIs, in terms of outreach and self-sustainability, has been disappointing—
though in recent years a few salient exceptions have been acknowledged. Since their
establishment, many DFIs have had to be repeatedly bailed-out and recapitalized due to their
inability to achieve financial self-sustainability despite the benefits of a plethora of annual
“regular” subsidies.

Renewed interest in enhancing the DFIs’ operations stems from two factors. The first is the
realization that financial liberalization that took place in many developing countries over the
recent years failed to attain the expected increase in servicing to the “priority” sectors and
target clientele by for-profit formal lenders. Hence, the void that was often created after
eliminating existing DFIs or substantially reducing their access to concessionary financial
resources resulted in cutting off or limiting access to financial services to the target clientele.
The second factor that explains the increase in interest in establishing or enhancing DFI
operations is rooted in the increased dissemination of knowledge that few DFIs have
achieved substantial outcomes with respect to outreach and subsidy independence. Also, in
case of a subsidized, large agricultural DFI, it was found that the social gains attributed to
efficient access to financial services far exceeded the value of the subsidies received by the
DFI41.

Often, DFIs face high correlated risks (e.g. small-scale farmers faced with very limited crop
choice are subject to both yield and price risks), asymmetric information problems

41
  Robert Townsand and Jacob Yaron, 2001. “The credit-risk-contingency system of an Asian development
bank.” Federal Reserve Bank of Chicago


                                                  68
aggravated by lack of clients’ financial statements, and political interventions in credit
alFILation. Deficient policies and institutions related to property and creditors’ rights,
unsound limitations regarding uses of collateral and weak enforcement systems also
contribute to the plight of many DFIs in developing countries.

Recently, developing countries have increasingly recognized the importance of a well
performing financial sector. Important changes in the global financial system and sweeping
or gradual reforms in these sectors call for redefining the role of the DFIs in many
developing countries. This is not a trivial but rather a daunting task since such redefinition
would necessarily be influenced by the long-lasting debate and lack of consensus regarding
the role of the state in ensuring a well-functioning financial market.

The proposed approach in this note is to thoroughly evaluate the costs, subsidies and
“products” of the DFIs. If properly implemented, this evaluation framework could serve
states, donors, DFI managements and the public in better evaluating and monitoring a DFIs
performance, with respect to pursuing extended outreach to target clientele and reducing or
eliminating the DFIs’ subsidy dependence. Moreover, this evaluation framework could serve
to efficiently decide the destiny of a DFI. It could provide conditions for further support
and better alFILation of predetermined subsidies to the quantity and quality of specific
”products” that are delivered by the DFI, thereby providing incentive for improved
performance and better targeting of clientele and “priority” sectors.

Duality of Objectives: Internal factors revolve around the unclear mandates and duality of
objectives faced by most DFIs, in that they were expected to maintain their financial and
institutional viability as a “bank” while simultaneously serving target clientele with financial
products that in most instances were found unattractive for profit maximizing. Such duality
creates a more complex and demanding situation with respect to performance assessment
compared to the relatively simple case of a profit maximizing financial intermediary that
conveniently renders itself to measuring return on assets, equity, and other financial ratios.

The Need for Meaningful Criteria To Assess DFI Performance. Performance assessment
criteria that could serve in evaluating DFI performance were, by and large, missing until the
beginning of the nineties. An illustration to the lack of agreed assessment criteria for DFIs’
performance is found in the excellent World Bank publication of the 1989 World Development
Report (WDR). The WDR reads:

“The Most common type of non-bank intermediary in developing countries is the
Development Finance Institutions (DFI). Most are public or quasi-public institutions that
derive much of their funding from the government or from foreign assistance. Originally,
they were intended to provide small and medium-size enterprises with the long-term finance
that the commercial banks would not supply. During the 1970s that mandate was
broadened to include the promotion of priority sectors. Using Government funds, DFIs
extended subsidized credit to activities judged unprofitable or too risky by other lenders. In
particular, the DFIs found it difficult to finance projects with high economic but low
financial rates of return and remain financially viable at the same time.” (WDR, 1989. pg.
106).




                                              69
The 1989 WDR rightly underscored the duality of objectives that DFI face, however, it
didn’t provide performance assessment criteria, let alone tools needed for quantifying costs
and relating them to products delivered by the DFIs. Moreover, thorough evaluations of the
subsidies and social cost of maintaining the DFI were often hampered by an over-reliance
on traditional accounting and financial ratios that provide, at best, a partial and often
misleading picture of the DFI performance because many of the DFI’s subsidies were not
reflected in their audited financial statements.

Ideally, we would like to know the real benefits to society generated from a DFI’s provision
of access to finance. To obtain such knowledge requires econometric measurements,
whereby a solid control group needs to be established. This is costly, requires high skilled
and lengthy commitments and therefore is only rarely carried out in the Bank or other
donor’s operations. Though, econometric measurements are warranted to better
comprehend the cost-benefit assessments associated with DFI operations, it is, however,
based on past performance, not realistic to assume that these would be carried out even in
one out of fifty Bank Financial Intermediary Loan (FIL) operations in which DFIs are
involved.. This begs the question of what performance criteria should be used to evaluate
the DFI’s operations short of econometric measurements?

Outreach and Self-Sustainability

A framework that was introduced in the early 1990s for assessing the performance of DFIs42
has gained wide acceptance among practitioners and academics. It proposes two primary
assessment criteria, outreach and self-sustainability (Figure 1 below).               Evaluating the
performance of DFIs based on these primary criteria could serve as an easily quantifiable
proxy of the impact of DFI performance. This framework doesn’t claim to capture the full impact
of the intervention at the level of the ultimate borrowers, whether the clientele to be served by the
intervention are exporters, farmers, urban poor or industrial entrepreneurs.

The Outreach Index (OI). A hybrid, the arbitrary Outreach Index (OI) can be developed to
reflect the priority and relative weights assigned to key indicators of outreach. The OI is
comprised of concrete output variables, examples of which may include value of the loan
portfolio, annual increase in loan portfolio, size of average loan, (as proxy for income level
served), and the percentage of female clients (when providing access to credit to women is
considered a social objectives). Thus, the OI is custom-designed and requires choosing
explicitly quantifiable output variables related to the subsidized intervention and agreement
on the relative weights of each variable. It should reflect the objectives and priorities of the
authorities that decide on and finance the intervention. As the OI highlights the cost-
effectiveness of various components, authorities may change these priorities over time and
simultaneously adjust the OI to better reflect changes in priorities.

FIGURE 1:



42   Yaron, J. 1992 (a). “Successful Rural Finance Institutions.” World Bank Discussion Paper 150. Washington,
     DC and World Bank and Yaron, J.1992 (b) “Development finance Institutions: Assessment of their
     performance.” World Bank Discussion Paper 174. Washington DC.


                                                       70
                                    DFI primary performace
                                            criteria

                         Outreach                                     Self-Sustainability
                        Hybrid Index                                 Composite Index: SDI
                    indicating target market                       measuring subsidies received
               penetration and quality of services               against interest earned by an RFI

             Examples of Indicators:                           Examples of Subsidies:
             • Number and value of total                       • Interest rate subsidy on
               deposits and total outstanding                    concessionally borrowed funds
               loans                                           • The opportunity cost of equity
             • Percentage of rural population                  • Reserve requirement
               served                                            exemptions
             • Annual growth rate in the                       • Government assumption of
               number and volume of total                        loan losses or foreign exchange
               deposits and total outstanding                    losses
               loans                                           • Free equipment or training
             • Variety of services offered                       provided by the government
             • Number of outlets                                 or donors
             • Percentage of women clients
43
 Source: Adapted from Yaron, Benjamin, and Piprek,1997, “Rural Finance:Issues, Design and Best
Practices” ESSD Monograph #14, WB publication.

The Subsidy Dependence Index (SDI). Self-sustainability is assessed by calculating the SDI of
the DFI, which indicates as a sensitivity analysis the percentage by which a DFI’s prevailing
average on-lending interest rate would have to increase to make it self-sustainable, i.e.
subsidy independent. The SDI also indicates the cost to society of subsidizing a DFI
measured against the interest income earned by the DFI in the marketplace. The SDI allows
the computation of the annual subsidy needed to maintain a $ of average annual outstanding
loan portfolio (OLP) of the DFI. This is an important indicator of efficiency. Such
measurement is based on the assumption that “benefiting from some level of concessionary
resources received from state and/or donors, the public funds entrusted to the DFIs are, by
definition subsidized, because the unfettered market would have charged higher rates for
these resources44.”

This type of analysis more fully takes into account the overall social cost of operating a DFI,
including the full value of subsidies received by the institution. In particular, the SDI makes
explicit the subsidy needed to keep the DFI afloat, much of which is not reflected in
conventional accounting and unable to be captured by traditional financial ratio analysis. The
main contributions of incorporating the SDI methodology are outlined in the Box 1 below.

43 For reviewing DFIs, various measurements of the subsidy dependence of DFIs or concessionary directed
lending programs see “Development Finance Institutions: measuring their subsidy” World Bank, series of
Directions in Development by M. Schreiner and J. Yaron, 2001, page 74.
44 Schreiner, M and Yaron, J. 2001. Development Finance Institutions: Measuring their subsidy. Directions in

  Development Series. Washington, DC: The World Bank.


                                                      71
Box 1: Contributions of the SDI Methodology

1. Often governments and development agencies do not know just how much their support for DFI costs
society since much of the subsidization is not explicit and is often clouded by non-standard accounting and
reporting. This knowledge is necessary; however, to compare support for the DFI with other uses of scarce
public resources. The numerator of the SDI quantifies the total explicit and implicit subsidies (including the
opportunity cost of the DFI net worth (equity) that benefited the DFI, thereby allowing cost comparisons with
programs achieving other essential social objectives.

2. The SDI compares subsidization with revenue from lending, and with the average annual OLP, thereby
providing the notion of a matching grant in that the value of subsidies received from society is measured
against the total interest and fees earned from its clients.



3. The SDI can be used to track subsidy dependence over time and can be used as a planning and monitoring
tool to track progress toward subsidy independence.

4. The SDI can be used to compare subsidy dependence of different DFIs in the same country or in different
countries that provide similar services to similar clientele.

Sources: Adapted from Shreiner and Yaron 1998; and Yaron, Charitonenko, and
Benjamin,1999,”Promoting Rural Financial Markets,” The World Bank Research Observer, Yaron,
J. 1992 (a). “Successful Rural Finance Institutions.” World Bank Discussion Paper 150.
Washington, DC, and World Bank and Yaron, J.1992 (b) “Development Finance
Institutions: Assessment of their Performance.” World Bank Discussion Paper 174.
Washington DC.
The Differences Between the OI and the SDI. There is a clear difference between the OI
and the SDI. The OI of financial products is a hybrid, arbitrary index and should reflect the
priorities and weights assigned to its components/”products, ” which may change over time.
The main advantage of the OI is that it forces the authorities that foot the subsidy bill to
clarify their objectives, priorities and more accurately define the target clientele. This, in
turn, allows a more precise measure of the related costs associated with achieving such
objectives by delivering the specific DFI“products.”
In contrast, the SDI is a comprehensive index that captures the full subsidy dependence of
the DFI concerned. Both the OI and the SDI can serve not only in shedding light on what
actually happened in the past but rather enrich the planning and budgeting of subsidies and
targeting of the “products” and clientele that is intended to be served.
Measuring the social cost of DFI operations is not a complex task. It requires, however, a
departure from exclusive reliance on financial accounting data that is presented in audited
financial statements–even when the generally accepted accounting principles (GAAP) are
adhered to by the DFI–to unearth subsidies that are not reflected in such statements such as
concessionary borrowing resources that benefit the DFI and the opportunity cost of the
DFI’s equity.




                                                     72
This, however, begs the question, if measuring the benefits of DFI operations is expensive
and complex what is the point in focusing only on measuring the costs? The answer is that
in many instances, it is instrumental to obtain the full, detailed picture of the costs and the
subsidy dependence of a DFI, even in the absence of having a full picture of the benefits to
society from the DFI’s operations.

                         BOX 2: Why Measure The Costs Even If Often We Don’t Know The Benefits?

 The SDI is useful in measuring the social cost of DFIs and thus as part of the process that allots public funds.
 It is useful even in the absence of measures of benefits, although the cost measurements should not be use to
 advocate for their relevance of benefits. An example is the issue of agriculture DFIs. It is expensive to
 measure the benefits of extension. In contrast it is inexpensive to measure the costs. Once, costs are known the
 pursuit of efficiency and improved social welfare can focus on down to earth questions. Is there a new
 technology that needs extension to speed its spread? Could farmers pay for it in view of its benefits? Should
 only rich farmers be asked to pay for it? Should fees be phased in? Would sub contractors cost less and
 provide better service than the employees of the DFI?

 Source: Adapted from “Development Finance Institutions: Measuring their subsidy” by M. Schriener and J.
 Yaron, The World Bank, series of Directions in development (2001).


Measuring the subsidies received by an agricultural DFI as detailed below, provided an
extremely different picture from what could be learnt from relying exclusively on audited
financial statements and computing the widely used financial accounting ratios. Much of the
subsidies this DFI benefited from couldn’t be captured from such analysis. The finding
based on unearthing the full value of subsidies indicate disproportionate low alFILation of
funds to basic education and preventive health compared to relatively extremely high DFIs
agricultural subsidies in a country with high rates of illiteracy and infant mortality. Such
finding could serve effectively leading to a more sound and different resource alFILation at a
macro level even without obtaining the full picture related to the value of benefits accrued to
agricultural borrowers of the DFI concerned.
.
Figure 2: Comparing DFI’s Agricultural Credit Subsidies with Funding for Preventative
Health and Basic Education in an African Country

                       450                                                                                                425
                       400
                       350
                       300
        US$ millions




                       250
                       200
                       150                                                  107
                                              76            90                             85
                       100      67
                                                                                                           52
                       50
                         0
                             1989 Credit   1990 Credit   1991 Credit    1992 Credit    1989-1992       Preventative   Basic Education
                              Subsidies     Subsidies     Subsidies      Subsidies    Average Credit      Health
                                                                                        Subsidies


                                                                       73
Source: Adapted from L. .Squire, and presented in “Rural Finance; Issues, Design and best Practice”
ESSD Monograph #14 1997 J. Yaron, M. Benjamin and G. Piprek.


It is imperative to evaluate and analyze the subsidies received by DFIs from a dynamic point
of view. Subsidies that are aimed at reducing asymmetric information contribute to
promotion of financial markets that rely on private agents, facilitating future lower
transaction costs and reduce loan losses, thereby paving the way to enhanced access to credit
and lower interest rate spreads. In contrast, lowering artificial lending interest rates to
ultimate “priority” borrowers with subsidies will not have a lasting impact but only adverse,
distorted impact on promoting financial markets and willingness of private agents to be
seriously involved in financial intermediation. When such concessionary resources can be
approached exclusively by state-owned, first-tier DFIs the outcome would be crowding out
of formal and possibly informal private creditors and creating unsustainable and inefficient
financial arrangement that runs counter to promotion of financial market with solid
participation of private agents.

A Second-Tier Apex DFI vs. A First-Tier DFI

Limiting state-owned DFIs to become a second-tier apex DFI that is responsible only for
alFILating funds to non-state-owned financial institutions that effectively provide access to
credit to well defined target clientele is likely to generate two substantial advantages when
compared to the widely spread pattern of first-tier state-owned DFIs that directly lend to
ultimate, “priority” clients. The first advantage is based on the plausible assumption that
private agents could more cost-effectively serve the designated, ultimate borrowers than the
first-tier state-owned DFI. Auctioning of subsidies by the second-tier state-owned DFI that
are tightly related to the “products” to be delivered by the first-tier private financial
institutions could enhance competition and generate transparency related to the costs,
subsidies involved and the actually beneficiaries from such intervention.

The second advantage is that a second-tier state-owned DFIs can serve efficiently as a
custodian of public resources and professionally apply economic criteria when alFILating
scarce public funds in pursuit of socially desired objectives, including monitoring the use of
such public funds and ensuring their utilization along cost-effectiveness criteria, without
being directly involved in lending to ultimate clients. This division of labor between private,
for-profit financial intermediaries and apex second-tier state-owned DFIs can resolve, to a
large extent, the duality of objectives that so far has characterized the DFI performance,
generated poor outcomes and provided a blurry assessment picture of financial and
economic results that in most instances fell short of quantifying the costs and subsidies from
which the DFI benefited.

Introducing, implementing and improving the use of the OI and the SDI by the second-tier
state-owned DFI could contribute substantially to both enhancing access to credit to priority
sectors, as well as reducing the subsidy dependence associated with facilitating such an
access. It should be noted, however, that a second-tier DFI is tantamount to a development
agency that decides among competing needs along economic criteria, on behalf of the fiscal
authorities, regarding alFILation of scarce public resources. It doesn’t, as such, constitute a
direct “banking” financial intermediation operation.

                                                74
 Box 3: A Second-Tier DFI that Performs as a Development Agency without Lending Directly to Ultimate
 Borrowers can be Characterized as:
         A flexible vehicle for implementing focused public policy
         Principally operating with budgeted fiscal transfers
         Determining its priorities by parliament within the framework of a budgetary process
         Developing its own evaluation and monitoring criteria–e.g., subsidy per unit of production and potential
          contribution to promotion of financial markets
         Assuming or not assuming partial financial risks of lending extended by first tier financial institutions.
          Ensuring appropriate use of subsidies that aimed at introducing and catalyzing the use of instruments
           that contribute to the promotion of financial markets.
 Source: Adapted from presentation of A. De La Torre, Mexico City, 2002




Conclusions and Recommendations

This note tried to cope with the long standing issue of what to do with state-owned DFIs
that in most instances are inefficient and sinkholes for subsidies. Yet, they are also often the
only means of providing financial services to certain segments of society.
DFIs are not likely to disappear soon, despite the poor performance of most.
A few of the DFIs have achieved substantial outcomes in terms of outreach to target
clientele and subsidy independence, or progress made toward subsidy independence.
Underscoring the need to systematically evaluate and measure the cost of their “‘products”
by introducing the OI and the SDI is likely to enhance transparency, and contribute to a
public debate regarding the social desirability of continued financial support to DFIs.
The transparency generated by introducing the OI and SDI would force many DFIs to
become more efficient as the creation of databases and ehance access to information would
allow for the comparison between costs of similar “products” to similar clientele.
Such transparency would pave the way to a more smooth closing of DFIs that are hopeless
and not ready to take the measures to become more efficient.
Limiting DFIs to second tier operations, acting as a custodians of public funds is likely to
enhance efficient use of these scarce funds, relieve state-owned DFIs from the need to face
the daunting dilemma of having to choose between serving the target clientele and
generating (almost always) financial losses or becoming subject to commercial imperatives
and reducing or eliminating the services rendered to the target clientele.
At the Macroeconomic level the proposed approach, when implemented, is likely to generate
in most instances, the financing of more socially desirable “products” to a better defined
target clientele at a lower cost to society.
Subsidies should be directed to become more cost-effective by promoting instruments that
would facilitate future markets based financial intermediation (credit registry, credit scoring)
instead of subsidizing lending interest rates to ultimate borrowers or inefficient DFIs
characterized by high SDI and poor OI.




                                                       75
This approach could substantially reduce rent seeking and incidences where DFIs suffer
from a mission “drift,” abandoning their target clientele in preference of serving the
relatively well-to-do, who grab much of the grant element embedded in the concessionary
lending rates, instead of servicing the designated clientele.
Furthermore, a new approach would allow and facilitate subsidizing (preferably through
auctions) “products” that contribute efficiently to promotion of financial intermediation by
private agents. Much of these subsidies can be capped per “product”, reduced over time and
finally eliminated. However, the difference here would be that the subsidies will be always
transparent.
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