Local Government Investment Financing
– understanding the LGFA concept
Regional and local authorities play a big role in building the infrastructure for the society to function well. It is therefore crucial that they have the proper means to finance these investments. Since these projects have a long lifetime borrowing is almost always an important part of the financing. In the last 60 years the banks have been one major supplier of loans to local authorities. There is now reason to believe that, with the restraints of the new regulation know as Basel III, the banks have to reduce their activities directed towards local authorities. It is safe to assume that bank loans will be more expensive due to the new rules. It is only the very big regional and local authorities that have used the financial markets to issue bonds as a way of financing. The reason for this is found in the way that the financial markets work.
An issuer of bonds in the financial markets needs to have big borrowing requirements
▪ in order to digest the transaction cost related to a bond issue, such as marketing, rating and legal support.
▪ in order to be able to supply the markets with liquid bonds, which means that each issuance must be of a significant amount.
▪ in order to be able to be a frequent borrower in the market, so that the markets will be acquainted with the issuer and price the bonds appropriately.
Furthermore the borrower needs to have considerable knowledge of the functions of the market and of the different financial instruments.
It is not possible for the vast majority of local authorities to directly use the financial market for bond issuance because of the reasons stated above. But the nature of local authorities of one country are very similar entities. Of course they could compete with the neighbouring local authorities, but it is not their aim to compete with others but to supply their own citizens with the best possible public services. For these reasons cooperation, in a number of fields, is very well suited for local authorities. Financial cooperation is specifically well suited for collaboration, since it will grant entry to the bond markets as a way of financing their investments.
One way of financial cooperation is to issue so called ‘Club-deals’. This means that a number of regional or local authorities join together for a single bond issue, where each involved entity is responsible for its share. The advantage of ‘club-deals’ is that one can achieve a sufficient amount for efficient use of the bond markets. The disadvantage is that it is a single bond issue that will not mean a frequent appearance in the market. Each ‘club-deal’ has to be put on the market in its own right and since different entities can participate in different deals, it also have to be individually credit rated. In order to optimise, the cooperation has to be taken a step further, but ‘club-deals’ could be a first step.
The form of local authority financial cooperation that has proved successful and enduring is Local Government Funding Agencies (LGFA). With a designated and formal cooperation entity with ongoing participation in the financial markets and with the possibility to employ staff with expert skills, the local authorities will have access to cost efficient funding of local infrastructure investments.
What is a LGFA?
First, we need to define the concept of municipal funding agencies. A useful definition is the following:
A municipal funding agency is a cooperation project between local authorities in a country. This means that the local authorities jointly own the agency, sometimes with a minor ownership buy the state. The agency is created for the good of the local authorities and does not seek to make profits. Surplus in the accounts of the agency is reinvested in the activities, with the aim of better serving the local authorities. Municipal funding agencies work solely (with lending) within the borders of their respective countries.
Although the term ‘Local Government Funding Agency’ is often used these agencies have also been called ‘Local government collective agency’ and ‘Municipal bond bank’ as well as ‘Agence de financement des collectivités locales’ (French) and ‘Kommunalen Finanzagentur’ (German).
Where do we find LGFAs?
According to this definition, it is possible to consider, for example, the following to be municipal funding agencies:
▪ Municipality Finance of Finland (link)
▪ Kommuninvest of Sweden (link)
▪ Kommunekredit of Denmark (link)
▪ Nederlandse Waterschapsbank of Holland (link)
▪ Emissionszentrale der Schweizer Gemeinden of Switzerland
▪ Cassa del Trentino of Italy (link)
▪ Municipal Finance Authority of British Columbia, Canada (link)
▪ The Alberta Capital Finance Authority, Canada (link)
▪ Municipal Bondbanks of the US (such as Maine Municipal Bond Bank, Vermont Municipal Bond Bank, Sunshine State Governmental Financing Commission and others)
▪ New Zealand Local Government Funding Agency Ltd (link)
▪ Japan Finance Organization for Municipalities (JFM, link)
KBN (Kommunalbanken Norway, link) could also be placed in the category of municipal funding agencies although it is owned by the state.
BNG (N.V. Bank Nederlandse Gemeenten, link) has many of the characteristics of a municipal funding agency, but there is one mayor deviation; they are engaged in lending to project outside of the Netherlands. This means that they are involved in business that can be compared to ordinary banking business.
Why should a LGFA be created?
The rationale behind establishing LGFA’s can be divided into the following points:
▪ Local authorities are by matter of definition small entities. Small borrowers – like small and medium sized municipalities – get less attention from banks and capital markets than big borrowers. This means that a large part of the financial markets are closed to small borrowers, whether they are public or private entities.
▪ A LGFA is potentially better equipped to market local government risk to the investors in the capital markets.
▪ Processing costs for pooled financing are considerably lower than if the local entities borrow on their own.
▪ Local governments often play crucial roles in the public sector of a country and has the potential of having high creditworthiness, especially if they cooperate in a LGFA.
▪ Financial expertise is often low in local authorities since their primary focus is on providing appropriate basic services to the public. The administrative staff of a local authority is often of a rather modest size.
There are a number of ways that LGFA brings about changes in the conditions of funding for the local administrations, but the LGFA will also give incentives for improving local administration itself and it will also generally influence the financial markets:
▪ In all of the known cases, the creation of a LGFA has led to cost reductions for the local authorities in their financial management.
▪ If the LGFA is operating in a free market with no state benefits or privileges (tax exemption, state guarantees) competition is boosted. The absence of a LGFA often leads to markets characterised by oligopoly consisting of a few commercial banks.
▪ The LGFA gives support and incentive to improve the local governments’ creditworthiness and will amplify the cooperating group’s joint creditworthiness.
A LGFA has the potential to be a centre for the transfer of knowledge to local authorities in the areas of financing, legal matters and in general administrative questions.