Public-Led Structured Finance: Overcoming Coordination Failures? Augusto de la Torre, Juan Carlos Gozzi, Sergio Schmukler Conference Access to Finance.

Public-Led Structured Finance:Public-Led Structured Finance:

Overcoming Coordination Failures?Overcoming Coordination Failures?

Augusto de la Torre, Augusto de la Torre, Juan Carlos Gozzi, Juan Carlos Gozzi, Sergio SchmuklerSergio Schmukler

Conference “Access to Finance”Conference “Access to Finance”

March 15-16, 2007March 15-16, 2007

World BankWorld Bank

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De la Torre, A., J.C. Gozzi Valdez, and S. Schmukler, 2006. Innovative Experiences in Access to Finance: Market Friendly Roles for the Visible Hand? World Bank Latin America and Caribbean Regional Study

Background MaterialBackground Material

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1. Role of the Public Sector

2. Two Cases

3. Final Thoughts

Structure of the PresentationStructure of the Presentation

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2. Two Cases

3. Final Thoughts


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Two contrasting and well-established views on the role of the public sector in broadening access to finance

Interventionist view

Laissez-faire view

Emerging, middle-ground viewPro-market activism view

Role of the Public SectorRole of the Public Sector

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Development policyStrategic or socially important sectors (SMEs, agriculture, low-income housing) are underdeveloped and will not take off by themselvesProtection (temporary) and government investment is needed Growth strategies focused on accelerating capital accumulation and technological adoption through direct government intervention

Financial sector policyWidespread market failures – markets will not finance take-offGovernment should mobilize and allocate finance to strategic or socially important sectors

Public banksA policy vehicle/instrument that is functional in this contextSelective allocation of credit could also be done via regulation of private banks

Administered interest rates, directed credit, refinance schemes

Interventionist ViewInterventionist View

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The general experience with public banking and direct lending in developing countries has not been successful

Government bank ownership associated with lower financial development, wider spreads, and slower economic growth

Major incentive and governance problems in public banks’ operations result in recurrent fiscal drains

Inherent contradiction between social policy mandates and pressures to avoid losses (“Sisyphus syndrome”)

There have been some exceptions (i.e., BAAC in Thailand)

Widespread government intervention leads to financial repression

Below market rates reduce savings and efficiency of the financial sector (McKinnon, 1973)

Low returns on financial assets encourages savers to keep their savings outside the financial system

Interventionist ViewInterventionist View

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Development policyDevelopment is hampered by heavy-handed government intervention

Government failure is widespread and outweighs market failures

Let markets breath and work (openness, privatization) and focus on strengthening “enabling” environment (macroeconomic stability, rule of law, property rights)

Financial sector policyLiberalize financial markets and shift focus to prudential oversightImprove contractual environment (creditor and minority shareholder rights, contract enforcement, accounting/disclosure, credit bureaus)

Public banksThey become de-contextualizedPrivatize or liquidate public banks (at least move to 2nd tier)Remaining public banks in search of new identity

Laissez-Faire ViewLaissez-Faire View

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However, improving the enabling environment for financial markets is not a straightforward process

Institutional arrangements are self-reinforcing (although not always efficient) due to substantial increasing returnsFinancial development is not amenable to a “one size fits all” approach due to its evolutionary, path-dependent nature

Despite intense reform efforts, access in most segments has not increased

Gap between expectations and outcomes might be explained by impatience or insufficient reform implementationDisappointment may also be explained by excessively high expectations at the beginning of the reform process

Institutional reforms take a long time to maturePolitical pressures to broaden access in the short runUnrealistic to expect governments to remain completely disengaged from any direct intervention during the long transition

Laissez-Faire ViewLaissez-Faire View

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Development policyLinks between reforms and development are elusive and studies of growth determinants give little policy guidanceIgniting growth and sustaining growth are different thingsProblems (poverty, low growth, inequality) are pressingBe heterodox, identify the binding constraint to mitigate second best

Need to avoid a template approach

Financial sector policyMarkets can and do broaden access to finance

Role of the government is to promote deep and efficient markets, not replace themInstitutional efficiency is the economy’s first best

However, well-designed, restricted interventions to address specific market failures can broaden accessGo back to basics, readjust expectations, and be creative

Pro-Market Activism ViewPro-Market Activism View

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New roles for the public sectorShare risk (e.g., through partial credit guarantees)

Pool risk and group otherwise atomized borrowers

Facilitate achievement of economies of scale to lower costs

Encourage adoption of technological and financial innovation

Solve coordination failures, aligning incentives of stakeholders

Type of activitiesSelective interventions

Relatively small and temporaryFocused on solving specific market failures in cost-effective mannerTailored to specific needs and institutional settings

Pro-Market Activism ViewPro-Market Activism View

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Public Provision of Market InfrastructureBANSEFI (Mexico)NAFIN’s Reverse Factoring Program (Mexico)Correspondent Banking (Brazil)

Structured FinanceFIRA (Mexico)

Credit Guarantee SystemsFOGAPE (Chile)

Transaction Cost SubsidiesSIEBAN (Mexico)

MicrofinanceBancoEstado (Chile)

Recent Pro-Market Experiences from Recent Pro-Market Experiences from Latin AmericaLatin America

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1. Access to Finance


3. Two Cases

4. Final Thoughts


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Problem: Coordination problem among stakeholdersFinanciers lack adequate information about borrowers

Agents with knowledge about borrowers lack funds to invest

Allocation of risks and costs among participants is not clear

Solution: Pooling and securitization of credit rightsAgent with informational advantage extends credit to borrowers, reducing principal-agent problems

Credit rights are transferred to a special purpose vehicle (SPV, separate legal entity)

Participations in the SPV are sold to investors

Pooling allows investors to diversify risk among many borrowers and reduce transaction costs

Clear assignment of risks and benefits among participants

Securities can be sold in tranches to achieve market segmentation and cater to different investors

Structured FinanceStructured Finance

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Some factors limit the penetration of structured finance in emerging markets

Lack of adequate laws and regulations

Unfamiliarity of market participants and seeming complexity of transactions

Tailor-made solutions may be costly to implement and require minimum scale

Structured FinanceStructured Finance

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Structured Finance – Case Study IStructured Finance – Case Study IFIRA Working Capital FinancingFIRA Working Capital Financing

FIRA is a Mexican development-oriented financial institutionProvides financial services to the rural sector

Shrimp producers had limited access to working capital finance Lack of collateral

Costly and difficult to screen and monitor small producers

Price uncertainty

FIRA created a structured finance program, involving Ocean Garden (large shrimp distributor), shrimp producers, shrimp feed suppliers, and private banks

Ocean Garden signs supply agreements with individual producers and advances working capital finance

Credit rights are then transferred to a trust fund and sold to banks

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OCEAN GARDEN

Functioning of Scheme

$100

SHRIMP PRODUCERS

BANKS

Supply Agreement

Loan for working capital $100

Transfer of credit rights

$100

FIRA

TRUST FUND

SHRIMP FEED

SUPPLIERS

Participation certificates

Payments

Feed


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OCEAN GARDEN

Functioning of Scheme in Case of Default

Guarantees (49%)

SHRIMP PRODUCERS

BANKS

FIRA

Individual guarantee (9%)

Default on supply agreement

Global guarantee (up to 25% of total fund value)

TRUST FUND

SHRIMP FEED

SUPPLIERS

Individual guarantee (15%)

Second loss guarantee (46%)


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Transaction helps to deal with information problemsOcean Garden provides know-how in screening and monitoring producers

Pooling of debt obligations allows banks to diversify their risks and avoid exposure to a specific producer

Banks do not face Ocean Garden’s credit risk (SPV is bankruptcy remote)

Pooling also reduces transaction costs

To align incentives all industry participants provide liquid guarantees to cover initial credit losses

Producer and feed suppliers provide guarantees for specific loans covering initial credit losses up to a certain levelOcean Garden provides a general guarantee covering initial credit losses up to a certain levelOnce these guarantees are exhausted investors start facing lossesFIRA provides a guarantee that covers second losses

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Structured Finance – Case Study IIStructured Finance – Case Study IIFIRA Inventory Financing – The ProblemFIRA Inventory Financing – The Problem

Banks not willing to lend to sugar millsSugar inventories not perceived as a good collateral

Movable collateral, difficult to secure

Lack of a warehousing market to guarantee value and quality of inventories

Difficulties in repossession and liquidation in case of default

Price volatility

Strong seasonal fluctuations in sugar cane pricesLack of integrated global markets

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Structured Finance – Case Study IIStructured Finance – Case Study IIFIRA Inventory Financing – The SolutionFIRA Inventory Financing – The Solution

Structured finance program, involving FIRA, Cargill, private banks, and sugar mills

Cargill grants credit to sugar mills backed by sugar inventories and then transfers credit rights to banks

Scheme has several built-in mechanisms to address problems of using sugar inventories as collateral

Cargill selects and monitors warehouses

A system of margin calls maintains a constant loan to value ratio, addressing concerns about price volatility

Loans are extended through repos, allowing easy repossession

Repo is legally a sale

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Pooling of debt obligations allows banks to avoid exposure to a specific mill and reduces transaction costs

FIRA’s provides credit guarantees covering a large share of the total value of loans

FIRA charges a fee for its credit guarantee

Cargill guarantees the purchase of most repossessed inventories

FIRA’s risk exposure is limited by this guarantee

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$80

CDs $100 Inventories $100

SUGAR MILL BANKS

CARGILL$80

Screening and Monitoring

Margin Calls

WAREHOUSES

Functioning of Scheme

FIRA

Funded Participation Agreement

CDs Repo

Sugar Inventories

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SUGAR MILL

CARGILL

WAREHOUSES

Functioning of Scheme in Case of Default

Guarantee $76.8

BANKS

FIRAInventories (book value $100; market value ?)

Put option $64

Inventories (book value $100,

market value ?)

Default

Loss:$3.2

Loss:$12.8

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FIRA plays multiple roles in structured finance transactions

Acts as a manager, setting up the structure and marketing the securities

Private firms may lack incentives to invest in developing innovative credit products

Provides credit guaranteesSince FIRA is a public institution, capital requirements on its guarantees are lower than those on private guarantees

FIRA requires banks to use its financingFIRA, as a second-tier lending institution, is evaluated on the basis of its loan disbursements

Structured Finance – Case StudyStructured Finance – Case StudyFIRA – ImplementationFIRA – Implementation

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2. Two Cases

3. Final Thoughts


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Current policy thinking is dominated by stability concerns and efforts to converge to international standards

Misguided view that financial development equals convergence to standards

Historically, standards came late in financial development, not at the beginning

Standards based on developed country institutional environments may have unexpected effects in emerging economies

Impact of Basel and AML regulations on access to credit for SMEs

Big emerging issues: completing financial markets in small economies in the context of financial globalization

International standards are largely unrelated to new challenges faced by financial systems in emerging economies

Final ThoughtsFinal Thoughts

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Is there a clear value added to pro-market activist interventions by the public sector?

Will the private sector do it by itself? If not, why?

If there is value added, what should be the optimal “visible hand” interventions?

Lender (1st or 2nd tier)? Risk sharer? Coordinator?

How to minimize unintended consequences of interventions?

Governments may be distracted away from the first-best solutionsGiven path dependence, second-best solutions may lead to traps that are difficult to exitGovernments may face political pressures to expand interventions and provide additional funds in the future

Need to establish clear sunset clauses


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Need to rethink some features of the financial institutions that promote development

• Institutions may have to start functioning more as development agencies than financial intermediaries

• Their mandate may need to be redefined in dynamic termsProvide incentives for institutions to move on to new activities once the market they were promoting becomes self-sustainable

• New products may require new methodologies for evaluating institutional performance

Evaluation based on credit volume perpetuates use of subsidized lending, even if liquidity is not a constraintEvaluation should focus on increase in financial activity generated

• Need to separate new instruments from other operationsProduct bundling reduces transparency


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Can idiosyncratic experiences lead to more general policy guidelines?

• What are the key features that make these interventions work?

• Can they be replicated in other sectors and other countries?

To what extent can we separate the organization (e.g., development bank) from the instrument?

Even if experiences are replicable, should the government create organizational capabilities where they do not exist?

Is there a role for pro-market interventions in the long-run?

• Are direct government interventions necessary once a good enabling environment is achieved?


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ENDEND

Public-Led Structured Finance: Overcoming Coordination Failures? Augusto de la Torre, Juan Carlos Gozzi, Sergio Schmukler Conference Access to Finance.

Documents

public sector slide

financial markets

development policy development

financial sector mckinnon

lower financial development

financial repression

financial innovation

financial assets