Deutsche Bank : | 22. Dezember 2015Promoting investment and growth: The role of development banks in Europe

Promoting investment and growth: The role of development banks in Europe

EU Monitor

Global financial markets

Author

Patricia Wruuck* [phone] [e-mail]

Editor

Jan Schildbach

Deutsche Bank AG Deutsche Bank Research Frankfurt am Main

Germany

E-mail: [e-mail]

Fax: [phone]

www.dbresearch.com

DB Research Management

Ralf Hoffmann

December 23, 2015

Promoting investment and growth: The role of development banks in Europe

* The author thanks Julius Böttger for excellent research assistance.

• The financial and economic crisis brought development banks back in the spotlight. They are seen as part of the economic policy toolkit for over- coming cyclical and structural difficulties in economies, complementing financial systems by improving their functioning and bolstering economic resilience. Interest in development banking to promote growth and boost investment has increased especially in Europe of late.

• Europe's promotional landscape has developed in very idiosyncratic ways resulting in a heterogeneous set of institutions operating between the state and the market. Despite their heterogeneity, they pursue quite similar goals.

• Given the current economic environment and changes in Europe's banking and financial markets, development banks are bound to continue playing an important role in the coming years. Rather than crisis relief, their focus is shifting (back) to supporting structural change in economies. Here, they can play a useful complementary role, focusing on areas of market failure.

• Risks lie with potential "overburdening" of development banks and setting expectations too high for what they can achieve. For individual entities and from a systemic perspective, the challenge will be to strike the right balance between competition and promotion.

Between the state and the market: Development banks in Europe 1

Sources: Investitionsbank Berlin, Deutsche Bank Research

Introduction

How to define a development bank?	2
Development banks are public entities, i.e. (a substantial portion of) their equity is owned by the state. Not all public banks are development banks, the latter are a subgroup. Other types of public banks are for instance postal banks and savings banks. Commercial banks can also be publicly owned. What distinguishes development banks is their mission, i.e. to promote economic development and other designated socioeconomic goals. These are typically stipulated in their mandate. 'State-owned financial institutions' is an even broader concept as it refers to financial institutions in general including - but not limited to - banks. The term includes inter alia commercial banks, development banks, leasing firms, credit guarantee funds and insurance companies that are publicly owned. Development banks are not necessarily banks "in the legal sense", they can for instance be established and operate as special public agencies. Their legal form and organisation may depend on local requirements, their historical development, policy choices, as well as their strategies, incl. refinancing and customers targeted. Entities that get their resources from special accounts (e.g. finance ministry or central banks) are often set up as funds rather than banks (UN 2005). While there is no fixed definition of a development bank, the Worldbank (2012) suggests that it is "a bank or financial institution with at least 30% state-owned equity that has been given an explicit mandate to reach socioeconomic goals in a region, sector or particular market segment." The UN (2006) defines them as "financial institutions set up to foster economic development, often taking into account objectives of social development and regional integration, mainly by providing long- term financing to, or facilitating the financing of, projects generating positive externalities".
Sources: De Luna-Martinez/Vicente (2012), UN (2005), Deutsche Bank Research

Since the start of the financial crisis an old concept is back in the spotlight: development banks. Credited with the ability to increase an economy's resilience by helping to cushion financing gaps in downturns as well as facilitating access to finance in areas that arguably face shortcomings, development banks are currently seen as part of the economic policy toolkit for overcoming both cyclical and structural difficulties in economies.

In the EU, grappling with the repercussions of the financial and debt crisis, debates about the role of development financial institutions (DFIs) have been particularly active lately.1 With the financial sector undergoing restructuring and

public finances often being stretched, they are seen as a way to improve access to finance, particularly for small and medium-sized enterprises, as well as helping to fund (long-term) infrastructure.

During past years, many DFIs in Europe have become more active. Several member states have reorganised DFIs or set up new institutions, others are considering doing so - all hoping to leverage their potential, promoting investment and growth. At the European level, the EIB has stepped up activity and this year the European Fund for Strategic Investments (EFSI) was established to promote investment - and ultimately growth - in Europe also via DFIs.

While DFIs have been a long-standing feature of financial and banking markets

- globally, and particularly in Europe - insights into how they work and the role they play for financial markets and economic policy remain rather limited. Most research analyses DFIs in developing economies. This paper offers a different perspective and focuses on DFIs in Europe against the background of developments in recent years and the current economic policy debate.

This analysis proceeds in four steps: The first part provides a brief introduction to the concept of development banks. The second part provides a mapping of European DFIs, assessing what they do and how they operate. Part three looks at their role in addressing the financial and economic crisis. This is followed by a discussion of recent trends and their implications for DFIs, as well as for financial markets and economic policy in Europe.

Development banks in brief

Development banks are a particular type of public financial institution with a dedicated promotional mission. They are typically set up by governments to offer credit and other financial services to clients that are not served by private financial institutions to the extent desired by policymakers.2 They are thus instruments for implementing economic policy goals.

Financial institutions to promote economic development exist and operate in practically all countries around the world. Historically, they have played an important role in fostering industrialisation, economic catch-up and to cope with periods of economic transformation. DFIs have been attracting attention recently due to their (potential) countercyclical role in economic crises and as part of a renewed discussion about the state's role in finance.

1 Albeit to some extent in a different context, the idea of development banks, particularly to support financing for infrastructure, has recently become more popular beyond Europe, too. Take, for example, debates in the US about establishing a new infrastructure bank, China founding the Asian infrastructure and development bank or the new BRICS development bank.

2 See De Luna-Martínez/Vicente (2012).

Development bank concept spread after

WW II 3

Share of development banks established in respective period (%)

60

50

40

30

20

10

0

In addition to national DFIs, multinational, regional and subnational institutions to promote economic development exist. They can be linked via cooperation on programmes or joint initiatives as well as via funding.

National development institutions around the globe come in very different shapes and sizes. They differ for instance on

• Ownership: Public ownership can be full or partial. Some institutions have subnational and national owners; others a mix of national, foreign, and multilateral ownership, involving for instance other DFIs as part of development cooperation.

• Funding, i.e. whether they are funded via deposits, raise money on capital markets, borrow from other banks, receive budget allocations from governments or use their own equity for activities. Most institutions rely on a mix of funding sources. If debt financing is used, a key distinction is whether debt issued by development banks is (fully) guaranteed by the state.

• Customers: These can include individuals, firms (both private and state-

before 1946 1946-1989 1990-2011

Based on global survey of development banks covering 90 institutions worldwide.

Sources: De Luna-Martínez and Vicente (2012), Deutsche Bank Research

Trends in government ownership of banks 4

Asset share of government-owned banks in the financial system (%)

25

20

15

10

5

0

owned), governments as well as other (development) financial institutions.

Typically, clients include private firms. Support to SMEs is almost ubiquitous but many DFIs also target larger firms.

DFIs mandates range from the general, e.g. "promoting economic development" the fulfilment of more specific tasks. For the latter, mandates define particular sectors or activities, for instance promoting agriculture or SME-financing.

Globally, the distribution between "generalist" vs. "specialist" development financial institutions is about even. In a recent survey of DFIs by the Worldbank, 47% of institutions state that they operate with a broad mandate, whereas 53% have a more specific one. In terms of sectors or tasks, agriculture, SMEs and international trade are the most common areas DFIs are tasked to support

globally.3

Some countries have several development institutions that operate at the national level, each with a dedicated sectoral or activity focus. Others have bundled different activities in one entity. What these institutions share - despite all their differences - is their public nature and a development mission.

Mitigating market failure is a major motivation

Theoretically, the DFI concept is linked with the concept of market failure. The reasoning here is that a functioning financial sector is vital to growth and economic development but that some financial services are underprovided in a free market setting. Establishing a DFI can be the best strategy to correct this.

Typical instances of market failure that underpin the existence of development banks and their activities are

Developed economies Developing economies

2001-2007 2008-10

Sources: Global Financial Development Report (2013), Deutsche Bank Research

• Costs of information and its asymmetric distribution - which may for

  instance underpin insufficient financing for SMEs

• Externalities - i.e. there are activities or projects that could be valuable to the country or community but because the benefits are difficult to appropriate, they have difficulties to attract enough funds, e.g. for climate and energy-related projects.

The market-failure argument suggests an important but complementary role for DFIs in the financial system. First of all, it provides a reason for their existence. At the same time, many controversies surrounding DFIs and their work stem from problems with defining market failure and disagreement about whether DFI intervention is the best way to mitigate it. Whether it is the best response

3 Ibid. Based on a survey of (national) development banks.

depends, inter alia, on the contracting environment and a government's ability to remedy market failure in alternative ways, for example via regulation, taxes or subsidies.

Views on DFIs also have been evolving in past decades from a more favourable stance (post-World War II), to a period of criticism stressing problems with political interference and inefficiencies to a more pragmatic approach that sees a valuable but limited role for them and emphasises the importance of good governance.

1st vs. 2nd tier lending models	5
Direct and indirect lending models each come with pros and cons: Direct (retail or 1st tier) lending models are sometimes associated with lower interest rates (no charges added by intermediaries) and DFIs can directly promote financial market develop- ment by setting up facilities in unbanked or underbanked areas. However, operating their own network increases costs for DFIs. DFIs operating with a 2nd tier (or wholesale) model can work with a leaner structure while still reaching a lot of customers. Private institutions and DFIs can share risks. Selection and risk-assessment for loans is done by partner banks. Typically, NPL ratios tend to be lower for such wholesale models. While the choice of lending models also reflects local market conditions, e.g. availability of commercial institutions to cooperate with as well as customer-bank relationships, 2nd tier models are often viewed as more "competition friendly" provided that DFIs work with partner banks in a non-discriminatory way.
Sources: De Luna Martinez/Vicente (2012), Deutsche Bank Research

What they do and how they perform

Lending models of development banks: Mixed models dominate 6

Both

What DFIs do and how they perform their role reflects both economic and political conditions. Typical activities include financing of agriculture, SMEs, international trade, housing, infrastructure and credit to local governments. Where financial markets are less developed, there is often greater emphasis on promoting general access to financial services, e.g. by offering micro-loans or acting as a deposit taker for households, and DFI activities can be very close to those of "ordinary" banks.

Development banks can lend directly to customers (1st tier/retail) or channel credit via other (private) banks (2nd tier/wholesale). Lending models again reflect local conditions to some extent: Direct lending can be the only way to reach customers in places where other financial institutions are absent or scarce. The 2nd tier model relies on cooperation with other banks who typically handle applications for loans by end customers. Globally, many development banks operate with a mix.

DFIs often provide services beyond loans and guarantees. These include venture capital, acting as business angels, leasing and factoring, securitisation as well as advisory services. Some are also active as long-term (strategic) investors.

Measuring the performance of DFIs is not an easy task because they are not meant to operate for profit, should focus on areas that are not commercially viable and play an enabling role in the economy. Hence, conventional metrics used to assess private institutions may only partly be applicable and need to be judged in reference to institutions' business models. The track-record of state- owned banks, which include DFIs, in terms of promoting general economic development, has been rather mixed. Studies have pointed out inefficiencies, potential political interference, capture by interest groups, as well as lack of clearly defined mandates.4 To that extent, research also suggests that the

institutional environment in which DFIs operate is important for their functioning and success.

Only

retail 36%

retail

and whole- sale 52%

DFIs in developed economies

Only whole- sale 12%

Shares based on responses by 90 development institutions worldwide

Sources: De Luna-Martinez/Vicente (2012), Deutsche Bank Research

DFIs are a common phenomenon in both developing economies as well as developed economies with relatively sophisticated and deep financial markets. In fact, some of the largest and oldest national DFIs are to be found in developed economies. They have traditionally been part of the economic policy toolkit and the financial market landscape, aiming to mitigate shortages in specific areas, such as long-term financing e.g. for infrastructure, but also providing credit to firms.

4 For example, LaPorta et al (2002) find that a higher share of government-owned banks in the financial system tends to be associated with slower subsequent financial development and lower growth. Beck and Levine (2002) similarly do not find positive effects. See for instance Global Financial Development Report (2013) and Rudolph (2010) for an overview. On political lending see for instance Sapienza (2004) and Ianotta et al. (2011).