Chapter 8: Municipal Pooled Financing Mechanisms

Lars M. Andersson
Lars M. Andersson is a local government finance expert, who in 1986 initiated the creation of the Swedish LGFA, Kommuninvest, and is now a board member of both the French LGFA, Agence France Locale, and the Global Fund for Cities Development (Le Fonds Mondial pour le Dévelopment des Villes, or FMDV).
Pavel Kochanov
Pavel Kochanov is a senior subnational specialist at the International Finance Corporation, where he specializes in credit and governance risks of sub-sovereign government entities.

Introduction

As the world’s population becomes increasingly urbanized—driven largely by population and migration trends in Africa and Asia— demand is rising for mechanisms to finance the requisite infrastructure development. One tool with great potential for many cities in the developing world is municipal pooled financing mechanisms (PFMs).

Broadly speaking, pooled financing entails gathering the borrowing needs of a group of municipalities and raising the combined debt on the capital market or from other sources of finance. This can be done either through a state governmental agency or through cooperation among local authorities.

PFMs do not remove the decision-making power of the individual local authority, and should be viewed as a complement to other funding sources. Large local governments like capital cities and their close peers can continue to benefit from direct access to bank financing and bond markets, choosing the most efficient source at a particular point in time. However, for most medium-sized and small local governments, municipal pooled financing may be the only mechanism that provides access to long-term and adequately priced debt financing.

PFMs have mainly been applied in the developed world; in the last 10–15 years, there have been few PFM experiments in developing countries. However, there is nothing preventing PFMs from becoming a much more common strategy around the world if the trend towards decentralization in developing countries continues; PFMs are a by-product of fiscal decentralization and the growing importance of local governments. Moreover, PFMs can be proactively initiated and implemented by policymakers in developing countries to deepen fiscal decentralization and increase its benefits. Thus, PFMs can play a crucial role in financing growing local infrastructure needs by giving local governments access to capital markets and by providing institutional investors with a new, attractive asset class. PFMs also foster participating local governments’ financial management capacity, accountability, and creditworthiness, making them stronger and more capable institutions. Financing infrastructure and building independent capacities in local authorities are particularly crucial concerns in the OECD economies, but even more so in places that are less economically developed.

As the world’s population becomes increasingly urbanized—driven largely by population and migration trends in Africa and Asia—demand is rising for mechanisms to finance the requisite infrastructure development.

Theoreticians did not create the PFM concept. It emerged organically and matured in several different economic and institutional environments through collaboration among local authorities and negotiations with other stakeholders. When thinking of the transfer of this experience to developing countries, the PFM concept should be viewed as malleable and variable in composition consider-ing the economic situation, local government structure, and other factors on the ground. It is not a one-size-fits-all scheme, but a project that needs to grow from the bottom-up to service particular contexts.

This chapter examines different types of PFMs around the world and describes how they function, explains how to develop PFMs, outlines the advantages and challenges entailed in implementing PFMs, and discusses the prerequisites for PFMs.

PFMs around the world

PFMs exist in many countries and have many different forms. In Europe, local government funding agencies (LGFAs) dominate. An LGFA is a special-purpose agency owned and, in most cases, guaranteed by local authorities and, in some instances, with minority shareholding by central government or other public stakeholders. It issues bonds in capital markets, domestically and internationally, and on-lends the proceeds to local authorities that are members/shareholders of the agency.

LGFAs have a long and successful history in Northern Europe. The oldest is the Danish agency Kommunekredit (see Case Study 1), created in 1898. The newest additions in Table 1 are the French Agence France Locale and the UK Municipal Bond Agency, created during the last few years.

Table
1
:
LGFAs around the world
Table 1

U.S. municipal bond banks have a slightly differ-ent set-up. They are usually closely related to various state governments. The oldest municipal bond banks are in the New England states, but the concept has also spread to other parts of the country. In Canada, there are provincial entities for financing local authorities in a number of provinces, including British Columbia (see Case Study 2) and Alberta.

The state-owned Japan Finance Corporation for Municipal Enterprises was converted into Japan Finance Organization for Municipalities (JFM), and in 2008 Japanese local governments became its owners.

The New Zealand LGFA was created in 2011 and, recently, the Australian state of Victoria formed its Local Government Funding Vehicle.

Also in emerging and developing countries, municipal pooled financing has been developed with the help of international development institutions. Two examples are the Indian Tamil Nadu Urban Infra-structure Financial Services Limited (TNUIFSL) and bond banks in Mexico. TNUIFSL is a public–private partnership with a wider scope of activities than, for example, the European LGFAs, since members of its staff also act as consultants and investment advisors. Mexican bond bank–type entities exist in the states of Hidalgo and Quintana Roo.

How do PFMs work?

To illustrate the fact that PFMs differ significantly in their operation, below we briefly explain how U.S. municipal bond banks operate and how select PFMs in other parts of the world function.

The municipal bond bank concept

Municipal bond banks exist in most cases as agents of state governments, organized as independent authorities with their own commissioners or boards of directors, many times appointed by the state governor.

There are around 15 U.S. bond banks in the same number of states. The oldest, Vermont Municipal Bond Bank, was created in 1969, and the youngest,

Michigan Finance Authority, was the result of the merging of various public finance authorities in the state in 2010. The most intense period of creation of bond banks was in the 1970s and 1980s, with only four bond banks created over 1990–2015. Bond banks are generally small and under the ownership and control of state governments. They are also directly or indirectly guaranteed by the states, and/or their bond issues are secured with interbudgetary transfers. Bond banks are predominantly found in smaller states.

The largest bond bank in terms of liabilities is the recently amalgamated Michigan Finance Authority. This entity has a broad scope, lending not only to municipalities, but also to schools (public and private), healthcare providers, and private colleges and universities. It also handles student loans in the state. The second-largest bond bank, Virginia Resources Authority, has a more typical set of customers and raises funds mainly for local infrastructure.

Overall, the size of U.S. bond banks’ activities is limited. Many bond banks administer statewide revolving funds from which loans are supplied to local authorities for specific purposes, often clean-water projects.

The cooperational approach

The cooperational approach is based on cooperation in the country in question among local authorities that have voluntarily joined forces to achieve long-term cost-efficient funding of local infrastructure projects.

The European LGFAs are examples of the cooperational approach. These agencies are frequent issuers in capital markets and are often market leaders in municipal loans in their respective countries.

Another example is found in Japan. Japan Finance Corporation for Municipal Enterprises was originally created as a central government institution in 1957. In 2008 this company was transformed into a new entity with the capital fully contributed by all local governments (prefectures, cities, towns, villages, and special wards of Tokyo) and became a joint fundraising organization for local governments.

Another example is found in New Zealand. The New Zealand Local Government Funding Agency (NZLGFA) was created in December 2011, after three years of preparations. Local authorities own 80 per cent of NZLGFA, and the central government retains the remainder. There are 31 shareholding local authorities; among these are the Auckland Council, the Christchurch City Council, and the Wellington City Council.

How is a PFM developed?

Development of a PFM can be divided into three levels: the preliminary level, the basic level, and the advanced level.

Preliminary level

A number of actions can be taken to prepare for the introduction of a PFM. A first step is the estab-lishment of close cooperation among local author-ities focused on financial issues, without actually borrowing together. This could entail the coordina-tion of borrowing activities and exchange of best practices regarding, for example, risk policies. This can include using similar procurement processes in relation to banks and other creditors.

Basic level                                                     

The basic level is a so-called club deal. This is a bond issue in which two or more cities participate, and it is done without a special purpose vehicle. Each participating city is responsible for its part of the payment of interest and capital. The main advantages of club deals are that they give small and medium-sized local authorities access to capital markets and that they are flexible in the sense that the group of issuers (local authorities) could be differently compounded for each club deal (bond issue). The disadvantage is that they are structurally and legally complicated, which produces costs that, to some degree, could offset a good pricing of the bonds.

The basic level is suitable for countries with institutional and/or legal constraints preventing the development of a PFM at the advanced level (see below). It could also be a step towards the advanced level, while giving involved local authorities experience with capital markets and testing the spirit of cooperation among these authorities.

Advanced level

The next step is to create an LGFA to act as an intermediary between the cities and the capital markets. The big advantage with an LGFA is that it can reach sufficient volumes in its borrowing to diversify its funding operations and achieve cost-efficient pricing in the capital markets. Diversification also means the reduction of risk given that the LGFA is not reliant solely on one source of funding or even on one market. The fact that an LGFA can employ financial experts to run the operations also reduces risk. This kind of entity must have economic strength to be credible to investors. Economic strength, which in this case is the same as creditworthiness, can be gained through sufficient capitalisation and can be reinforced by guarantees. The guarantors can either be the participating cities, central government, a third party (e.g., public sector pension funds), or a mix of these. The advantage of having a guarantee from the participating cities is that it reinforces the local responsibility for the LGFA.

Aerial view of residential area in Grenada North, Wellington, New Zealand

What are the advantages and challenges of PFMs?

Applying PFMs has several potential advantages:

  • It gives small and medium-sized local authorities access to capital markets. Capital markets require volume, and PFMs make it possible for small and medium-sized local authorities to coordinate their borrowing in bond issues that have the size required to attract investors.
  • It reduces borrowing costs. In all countries where PFMs for local authorities are applied, the cost of borrowing has been substantially reduced.
  • It reduces processing costs. Processing costs for pooled financing are considerably lower than if the local entities borrowed on their own.
  • It reduces market risk through diversification. Diversification of borrowing can be achieved by the use of different markets and different instruments, and by targeting a number of different investor groups. Because of the size of its operations, a PFM entity has far more potential to diversify its funding than a single local authority. Diversification can be achieved by using a number of loan products, loan programmes, and markets.
  • It improves debt management capacity by providing financial expertise. Financial expertise is often scarce in local authorities, since their primary focus is on providing appropriate basic services to the public. Cooperation provides opportunity to employ financial experts, which reduces risks.
  • It provides incentives to improve credit-worthiness. The participating local authorities have to agree to be supervised by their peers, because local authorities’ creditworthiness is the enterprise’s most important asset. This supervision can result in peer pressure to increase local creditworthiness. Peer pressure has often proven to be the most efficient way of improving local performance.
  • It is a conduit for the transfer of knowledge. The existing PFM entities regularly organize conferences, workshops, and consultations.
  • It increases transparency. A PFM entity has to apply a high degree of transparency for a number of reasons. First, the capital markets and international credit rating agencies will require full disclosure of financial information of the agency and participating authorities. Second, the most important asset of a PFM entity is its creditworthiness. The latter, in turn, is built upon the creditworthiness of the participating cities, which is why the financial status of these has to be monitored on an ongoing basis. It is also essential that the entity is transparent and that it issues comprehensive reports of its activities for the benefit of the involved cities and other stakeholders. Thus, financial information has to be freely supplied by the cities in the PFM. A large portion of this information will be public, which means that it will enhance public under-standing of the authorities’ activities and thus support local democracy.

There are also several challenges entailed in applying PFMs:

  • Administrative challenges: The central government has in many countries shown an initial hesitation to support local government initiatives to introduce PFMs. It is crucial that the central government is aware of the project’s benefits to the country’s development and hence to economic growth. It should also be made clear that a PFM entity’s activities will be guided by strict internal risk management regulations.
  • Market challenges: If there is one or a group of dominating lenders to local authorities, they are likely to feel challenged and to find weaknesses in the PFM plan. It is thus important to find ways to cooperate with existing lenders. The other market challenge is to raise interest among investors for bonds issued by a PFM entity. Contacts with investors should be made at an early stage to investigate how investors’ interests could be accommodated within the project and to give the investors time to prepare for the first bond issue. This might mean amending their internal investment regulations, among other things. Well before the first bond issue, an extensive program of so-called road shows must be executed.
  • Cooperation challenges: In many countries, local authorities are not accustomed to cooperating with each other. Clear governance rules have to be put in place. In addition, a need to supervise the creditworthiness of the participating local authorities could complicate cooperation. It is crucial that every member/shareholder fully accepts the need for continuous scrutiny and acknowledges that membership/shareholding does not secure an unconditional right to borrow from the entity.

For entities in emerging and developing countries, a further challenge is to build a system for secure repayment of the loans. This might mean that the entity and its members create a fund to secure future payment of the borrowing activities and/or acquire a third-party guarantee, which could be underwritten by other domestic stakeholders (central government, developing banks, etc.) or by development finance institutions. It should be stressed that external guarantees will have to be structured in a way that does not remove the responsibility of the local authorities that have created the entity. For example, a partial credit guarantee with recourse claim may help to improve the credit rating of the debt issued by the entity to make it eligible for institutional investors, without alleviating credit pressure on local governments.

What are the prerequisites for a PFM?

In order to introduce a PFM, the following basic conditions should be in place:

  • A willingness among the local authorities to cooperate
  • Sufficient creditworthiness of the participating local authorities
  • A legal system that allows local authorities to borrow, even though it could be within limits set by the central government or other central authorities
  • A legal system that allows local authorities to cooperate and to jointly assume commitments
  • A domestic capital market that has reached a certain degree of maturity with investors that could potentially be interested in local government bonds with medium- and long-term maturities

Even if all these conditions are met, non-market or concessional lending of national and international development institutions, state-owned banks, or central governments themselves can potentially undermine a PFM. Although concessional financing is not sufficient and not flexible enough to cover all the borrowing needs of local governments, it still makes it more difficult for local authorities to justify the development of market-based borrowing practices. And PFMs are indeed market-based mechanisms, which significantly reduce a need for debt interventions by central governments and development finance institutions.

These are the basic conditions, but above all there must be a need, obvious to local authorities, for new financing solutions. These local authorities must also be convinced that pooled financing could be a way forward. The next step is to get the support from central government.

Unfortunately, in many countries there has been an initial hesitation for municipalities to cooper-ate. This is probably because municipalities often see themselves as competitors to the neighboring local authority. Sometimes there could also be an element of distrust among municipalities. This can stem from different political parties being in power or a number of other reasons.

In countries where municipal funding agencies have been created, these challenges have been present. Fairly soon in the process it is recognized by the local authorities that a PFM is for the benefit of all participants, but it is still important to, in different ways, enhance trust among municipalities. The process needs to start with a few motivated stake-holders that can lead the way for others. These initiators must clearly state their interest in studying the introduction of a PFM in order to build a strong enough foundation for a project.

The work to create a PFM entity should be properly organized. A local government association could host the project and supply administrative support. It is important to remember that it is the local authorities that should drive the project. A step that is key in this type of process is the recruitment of leaders, both political and professional. A need for entrepreneurial skills cannot be underestimated. It is a question of breaking new ground, and it requires hard work and creativity combined with diplomacy.

The value of the process

All uses of financial markets for borrowing purposes are built upon good creditworthiness. The situation for local authorities varies greatly among different countries. For some developing countries a PFM is perfectly feasible, while other countries’ local authorities lack steady income streams and a solid regulatory framework. Nevertheless, all countries and their local authorities could make substantial gains from the process towards a PFM.

A project that aims to put in place financial cooperation among cities in a developing country addresses almost all the questions that are vital for well-functioning local authorities. These include:

  • What is the relationship between local author-ities and central government, both legal and financial?
  • What is the flow of income (including stability, predictability, diversification, trends [especially of tax bases], system for collection, collection rates, and the possibilities to tap new local taxes)?
  • What is the cost structure?
  • What is the debt outlook (e.g., size, interest payments, maturities, payment record, and central government restrictions)?
  • What institutional factors are present (e.g., organization, accounting system, audit, level of knowledge, and skills)?

All of the above constitute a well-functioning local authority with high creditworthiness.

Asking these questions in connection with a project that aims to solve a major problem, such as financing infrastructure investment, can be very efficient. It would enable putting needed reforms in the context of a vision for the future. A project would be organized in a way that makes clear the inter-relations among the different steps required for a stronger city. The fact that this kind of project encompasses a group of cities means that the demands on the central government could be stronger and more stringent. The negotiating power that such a project would gather is great, because it strives to resolve an undisputable need for financing for local infrastructure and it would be formed by a group of strong local authorities with comparably high creditworthiness.

In the global arena, the implementation of municipal pooled financing mechanisms is still to be recognized as an essential element of an effective fiscal decentralization—one that is intended to make local government fiscally stronger, more creditworthy, and more capable of addressing local infrastructure challenges. Otherwise, decentralization can only shift greater responsibility for infrastructure to local governments without helping equip them with the proper tools, such as access to capital markets.

Conclusion

The use of PFMs has the potential to not only provide cost-efficient funding for local infrastructure investments, but also to increase transparency and facilitate capacity-building among local authorities. The creation of PFM schemes is always dependent on the specific circumstances of each country. And there are many ways to organize PFMs, from a first step of inter-city cooperation to the creation of a special vehicle or agency. Such agencies can assume the role of local infrastructure development agencies, which would, together with cities and other local authorities, play the important role of facilitating efficient and resilient local infrastructure investment activities, with the potential to promote countrywide growth.

Case study
1
:
Kommunekredit, LGFA of Denmark

Denmark has a population of 5.6 million and is divided into 98 local authorities. The country is one of the most decentralized in the world. Danish local authorities created Kommunekredit in 1898 as a cooperative society. It is voluntary to join and over time all local authorities have become members.

Kommunekredit’s business model is similar to that of other European LGFAs. It issues bonds in domestic and international capital markets and on-lends the proceeds to local authorities and to related entities (for example, municipal-owned companies). When bond issues are made in foreign currencies, they are exchanged into domestic currency by the agency through the use of swaps. All lending is made in domestic currency. Kommunekredit has now achieved almost a 100 per cent market share in lending to local authorities.

Like the Swedish Kommuninvest, Kommunekredit is backed by a joint-and-several guarantee signed by all members. Neither Kommunekredit’s nor Kommuninvest’s guarantees have ever been invoked.

Kommunkredit has credit ratings of AAA/Aaa from S&P and Moody’s, respectively.

Unlike all other European LGFAs except the UK Municipal Bond Agency, Kommunkredit is not considered a financial institution under domestic or EU law.

At the end of 2015, Kommunekredit’s total lending reached DKK157.7 billion (US$23.7 billion). It is administered by 62 full-time employees at a cost, in relation to the lending, of six basis points.

Case study
2
:
Municipal finance authority (MFA) of British Columbia, Canada

The province of British Columbia (BC) has a population of 4.6 million and is divided into 162 local authorities within 28 regional districts.

The MFA is a non-share capital corporation and was established in 1970 under the provincial Municipal Finance Authority Act to provide long-term and short-term financing for regional districts and their member municipalities, regional hospital districts, and other public institutions in British Columbia.

Long-term debt requirements of local governments (five to 30 years), excluding the City of Vancouver, must be borrowed through the MFA.

Over the years of its operation, MFA’s objectives and activities have expanded to include short-term investment opportunities, interim financing, and leasing.

The MFA is independent from the province of British Columbia and operates under the governance of a board of members with 39 members appointed from each of the 28 regional districts within the province of British Columbia. A board of 10 trustees is elected annually from the members to exercise executive and administrative powers including policy, strategy, and business plans.

The MFA has Aaa/AAA/AAA ratings from Moody’s, S&P, and Fitch, respectively. These credit ratings are broadly based on the fact that the MFA’s borrowing is backed by a joint-and-several guarantee of members within the regional districts (but not jointly for all regional districts) and on the fact that it has unlimited taxing powers on all taxable properties in the province of British Columbia.

At the end of 2015, the MFA’s outstanding loans reached CAD4.6 billion (US$3.5 billion). It is administered by nine employees at a cost, in relation to lending, of less than one basis point.

Further reading

For more information about PMFs, please see these resources:

Lars M. Andersson, Finance Cooperation Between Local Authorities in Developing Countries (Stockholm, Mårten Andersson Productions, 2014).

Lars M. Andersson, Local Government Finance in Europe: Trends to Create Local Government Funding Agencies (Stockholm, Mårten Andersson Productions, 2014).

Lars M. Andersson, What the World Needs Now… Is Local Infrastructure Investments Challenges and Solutions with a Focus on Finance (Stockholm, Mårten Andersson Productions, 2014).

Lars M. Andersson, Overview of Municipal Pooled Financing Practices (Washington, International Finance Corporation, 2015).

Barbara Samuels, The Potential Catalytic Role of Subnational Pooled, Financing Mechanisms (Paris, FMDV, 2015).