Smart development banks

Fernández Arias, Eduardo; Hausmann, Ricardo; Panizza, Ugo Working Paper Smart development banks IDB Working Paper Series, No. IDB-WP-1047 Provided in Cooperation with: Inter-American Development Bank (IDB), Washington, DC Suggested Citation: Fernández Arias, Eduardo; Hausmann, Ricardo; Panizza, Ugo (2019) : Smart development banks, IDB Working Paper Series, No. IDB-WP-1047, Inter-American Development Bank (IDB), Washington, DC, https://doi.org/10.18235/0001845 This Version is available at: https://hdl.handle.net/10419/208197 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc-nd/3.0/igo/legalcode Smart Development Banks Eduardo Fernández-Arias Ricardo Hausmann Ugo Panizza IDB WORKING PAPER SERIES Nº IDB-WP-1047 A ugust 2019 Department of Research and Chief Economist Inter-American Development Bank A ugust 2019 Smart Development Banks Eduardo Fernández-Arias* Ricardo Hausmann** Ugo Panizza*** * Inter-American Development Bank ** Kennedy School of Government and Center for International Development, Harvard University *** Graduate Institute, Geneva and Centre for Economic Policy Research Cataloging-in-Publication data provided by the Inter-American Development Bank Felipe Herrera Library Fernández-Arias, Eduardo. Smart development banks / Eduardo Fernández-Arias, Ricardo Hausmann, Ugo Panizza. p. cm. — (IDB Working Paper Series ; 1047) Includes bibliographic references. 1. Development banks. 2. Industrial policy. 3. Industrial productivity. I. Hausmann, Ricardo. II. Panizza, Ugo. III. Inter-American Development Bank. Department of Research and Chief Economist. IV. Title. V. Series. IDB-WP-1047 Copyright © Inter-American Development Bank. This work is licensed under a Creative Commons IGO 3.0 AttributionNonCommercial-NoDerivatives (CC-IGO BY-NC-ND 3.0 IGO) license (http://creativecommons.org/licenses/by-nc-nd/3.0/igo/ legalcode) and may be reproduced with attribution to the IDB and for any non-commercial purpose, as provided below. No derivative work is allowed. Any dispute related to the use of the works of the IDB that cannot be settled amicably shall be submitted to arbitration pursuant to the UNCITRAL rules. 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The opinions expressed in this publication are those of the authors and do not necessarily reflect the views of the Inter-American Development Bank, its Board of Directors, or the countries they represent. http://www.iadb.org 2019 1 Abstract* The conventional paradigm about development banks is that these institutions exist to target well-identified market failures. However, market failures are not directly observable and can only be ascertained with a suitable learning process. Hence, the question is how do the policymakers know what activities should be promoted, and how do they learn about the obstacles to the creation of new activities? Rather than assuming that the government has arrived at the right list of market failures and uses development banks to close some well-identified market gaps, this paper suggests that development banks can be in charge of identifying these market failures through their loan-screening and lending activities to guide their operations and provide critical inputs for the design of productive development policies. In fact, they can also identify government failures that stand in the way of development and call for needed public inputs. This intelligence role of development banks is similar to the role that modern theories of financial intermediation assign to banks as institutions with a comparative advantage in producing and processing information. However, while private banks focus on information on private returns, development banks would potentially produce and organize information about social returns. JEL classifications: G21, G28, G14, L32, O25 Keywords: Market imperfections, Industrial policy, Public banks * Fernández-Arias is an independent consultant (at the Research Department of the Inter-American Development Bank at the time of writing); Hausmann is at the Kennedy School of Government and is Director of the Center for International Development at Harvard University; Panizza is at the Graduate Institute, Geneva and Centre for Economic Policy Research. This paper originated as a background paper for the IDB’s Development in the Americas report Rethinking Productive Development; this version was prepared for a special number on new industrial policy in Journal of Industry, Competition and Trade (JICT) edited by Karl Aiginger and Dani Rodrik (forthcoming 2019). The views expressed in this paper are the authors’ only and need not reflect, and should not be represented as, the views of any of the institutions that the authors are or have been affiliated with. 2 1. Introduction Structural change towards high-productivity activities is the main driver of economic growth. This paper studies how state-owned development financial institutions, development banks for short, can be rethought and redesigned to better help the adoption of productive development policies fostering structural change. The ups and downs of development banks over time illustrate well the need for rethinking their role to make them an effective tool for economic development. Fifty years ago, development banks were regarded as the centerpiece of a development strategy. By the 1970s, the public sector owned two-thirds of the assets of the largest banks in developing economies, and more than one third of the assets of the largest banks in advanced economies (IDB, 2005).1 Nevertheless, they were regarded as a mixed blessing. Their leading role back then was associated with key structural changes but also, too many times, with “white elephants,” questionable lending practices, and runaway losses. In the 1980s, critics started to sound louder. The generalized economic crises that followed the oil shocks of the 1973 and 1979, as well as the 1982 sudden stop in capital inflows to developing economies, led to a sea change in the consensus view on the role of the state in economic development as part of the so-called Washington Consensus. The perception that government failures are more costly than market failures brought many economists and policymakers to the conclusion that public intervention in general, and state ownership of banks in particular, stunted, rather than promoted, financial and economic development.2 This change in the view on the role of the state in the economy, together with the fact that all advanced economies and most emerging and developing countries had by then built large and vibrant private financial sectors, led to several waves of bank privatization which greatly reduced the presence of the state in the financial system (it is estimated that 250 financial institutions were privatized between 1987 and 2003).3 1 In Latin America, for instance, development banks played a central role in the import substitution strategy in the region. 2 For a discussion with somewhat contrasting views see Levy Yeyati et al. (2007) and La Porta, López-de-Silanes and Shleifer (2002). 3 In Latin America, the rolls of ALIDE, the association of public banks, shrank from 171 to 73 in that period. Liquidations included major banks in Peru, Mexico, Colombia, Venezuela and Nicaragua among others; many others were downgraded. 3 However, the subsequent exhaustion and failure of the Washington Consensus as a development strategy led to the concern that the backlash against development banks may have thrown out the baby with the bathwater. With the eruption of the global financial crisis in 2008, there has been an expansion of the role of state-owned banks to counteract the contraction of the private system (World Bank, 2013), sowing the seeds for their resurgence. The current lack of clarity concerning the role of development banks lends high priority to rethinking their role and redesigning their operation to avoid the vices of the past. The resurgence of the debate around a new generation of development banks to advance productive development policies jibes well with recent research on the critical role of public-private collaboration in this regard (FernándezArias et al., 2016). The reality is that development banks do many things, pursuing many objectives but not always with clear purpose. A survey of 90 national development banks in 60 developing and transition economies (de Luna Martínez and Vicente, 2012) found that 53 percent of the institutions covered by the survey have a specific mandate. These specific mandates target the following market niches: agriculture (13 percent of surveyed institutions); small and medium enterprises (12 percent); international trade (9 percent); housing (6 percent); industry and other sectors (6 percent); infrastructure (4 percent); and local governments (3 percent). The remaining 47 percent of surveyed institutions have a general mandate, such as promoting economic development.4 However, while only 12 percent of surveyed institutions have a specific target about small and medium enterprises (SMEs), 92 percent responded that they target SMEs. In fact, 60 percent responded that they target large corporations, 55 percent responded that they target individuals and households (versus 6 percent of institutions with a narrow housing finance mandate), and 54 percent responded that they target other state-owned enterprises. With respect to economic sectors, 86 percent of the surveyed institutions lend to the service sector, 84 percent to industry and manufacturing, 83 percent to agriculture, 74 percent to construction, 66 percent to energy, and 65 percent to infrastructure. These data suggest that even institutions with a narrow mandate seem to target different types of borrowers and economic sectors in an ad hoc fashion, without a clear rationale. 4 Gutiérrez et al. (2011) cite a 2009 survey by the Business Development Bank of Canada that surveyed 373 development institutions in 92 countries and found that the six most common target sectors for development banks are i) start-ups; ii) SMEs; iii) international trade; iv) housing; v) infrastructure; and vi) agriculture. 4 Development banks appear ripe for a reform agenda focused on how to fulfill their strategic objective of economic development. Subsidized lending to SMEs may be futile or counterproductive on productivity grounds unless such lending targets young firms that bring innovation and have high-productivity potential (see IDB, 2014). There may be good social or political economy reasons, such as cushioning unemployment or fighting inequality, for lending to traditional agriculture or providing housing credit, and some of these interventions may be well justified by market failures. But providing financial assistance to these activities can, at best, only have limited effect on the major obstacles to structural transformation and the emergence of new highly productive sectors. In this paper, we will focus our attention on the activities of development banks that are designed to have a direct effect on increasing productivity, especially on those that build productive capacities and stimulate positive structural change. We define development banks as government-owned financial institutions that have the objective of fostering economic or social development by financing activities with high social returns.5 As mentioned, we concentrate on activities with a productivity-enhancing objective. Best practices based on this vision of development finance suggest that development banks need to target well-identified market failures, addressing them through financial support at suitably easy terms while making sure that they do not distort markets by unfairly competing with efficient private banks. While these best practices are well rooted in economic theory, their implementation leads in most cases to mixed and lackluster performance. This paper analyzes what is going wrong. Specifically, it argues that the requirement that development banks only address well-specified market failures implicitly makes the unwarranted assumption that the bank’s management (or the bank’s principal, i.e., the government) has a good understanding of the existing market failures and knows what is the best way to address them through lending (or other appropriate financial instruments such as guarantees).6 In fact, policymakers cannot directly observe and ascertain the market failures that development banks are supposed to address and may easily give the wrong marching orders. 5 In this paper we concentrate on development banks and do not consider state-owned financial institutions that operate like private commercial banks and do not have an explicit development mandate. However, the distinction between these two types of institutions is not always clear (de Luna-Martínez and Vicente, 2012) 6 In order to simplify the exposition, when specificity is not of the essence, “lending” means any financial support, not necessarily a credit operation. 5 The successful implementation of the development bank paradigm requires deep knowledge of market failures, especially because economic development requires structural transformation and, in turn, structural transformation requires the creation of new activities which may be impeded by non-observable market failures. How do the bank’s decision-makers know what activities should be promoted, how do they learn about the obstacles to the creation of new activities? How do policymakers obtain this information? How does the development bank ensure that projects that commercial lenders choose to reject are worth the risk because of a high social return? How do they know how to calibrate better-than-market inducements, enough to bring in all of the repressed high social return activities that the commercial system leaves aside but making sure that excessively cheap terms do not result in giveaways and wasteful projects? In other words, how does one build a mechanism that enables learning about market failures? On the bright side, banks have a unique vantage point for observing not only market failures but also government failures, and in this way uncovering the obstacles to firm creation and firm growth. Development banks are institutions that lend themselves to public-private collaboration. They are special because they can learn by lending to firms, and this learning by lending creates complementarities that are important for a development bank as an instrument of economic development. In this paper, we make the case for a new role of development banks that exploits these complementarities between financial assistance and the design of productive development policies. Specifically, we propose that development banks be deployed as an instrument of economic intelligence and play an active role in the design, as well as implementation, of productive development policies. Deeper policy involvement would make development banks more accountable and facilitate the evaluation of their performance on substantive grounds, as opposed to bureaucratic lending targets. This new approach also has implications for the organization of development banks concerning the tradeoff between first-tier and second-tier schemes. Since first-tier banks are in direct contact with clients, they may be better positioned to perform this new role compared to second-tier banks. In what follows, the paper reviews the traditional modus operandi of development banks and elaborates on the new role proposed, discussing some key issues concerning how to set up development banks to be successful and an agenda for institutional reforms of development banks. The analysis is buttressed with the experience of a number of development banks 12 a few. To guard against the damage caused by governance failures, the traditional best practices view envisions development banks as financial organizations aimed at dealing with market failures that are explicitly mandated to limit the risk of encroachment into the private financial system and that are constrained to work within a tight financial envelope of fiscal resources to make sure that financial risks are contained. This view encapsulates the successful operation of a development bank according to the three conditions set forth by Gutiérrez et al. (2011): i) there is a well-identified market failure, and financing by a development bank is the most effective way to deal with this particular market failure; ii) lending by the development bank does not crowd out the private sector; and iii) the development bank is financially sustainable, generating sufficient resources to achieve its mandate without being a financial burden for the State. Establishing the first two conditions in practice may be difficult. For example, assume that we observe a development bank serving a market for which there are no commercial bank suppliers. It is legitimate to ask whether the development bank is filling a gap left by commercial banks or, on the contrary, is the reason why commercial banks do not enter this market. To give a specific example, in Brazil there is a debate on the role of BNDES. Some argue that BNDES plays a useful role in providing long-term credit because commercial banks do not do so. Others suggest that commercial banks do not extend long-term loans because of the dominant and privileged position of BNDES in this segment of the market. In the first case, BNDES is providing needed long-term credit that commercial banks would not provide (presumably because of a market failure). In the second case, BNDES is crowding out commercial banks from providing long-term credit (presumably more efficiently). A corollary of the first two requirements is that development banks should have appropriate stringent eligibility criteria for financial assistance to minimize crowding out financial markets. In practice, a restrictive mandate related to the market failure identified is often used as a blunt proxy to define eligibility. In this second-best logic, banks with a narrow mandate tend to be preferable to banks with a broad mandate. While a narrow mandate has some costs in terms of flexibility to successfully target market failures, Rudolph (2009) and Scott (2007) maintain that the freedom of broad mandates leads to mission creep, causes bank managers to lose focus and compete with the private sector, and reduces the overall transparency of the institution. Scott (2007) concludes by suggesting that policy mandates should be as narrow and as explicit as possible. At the same time, however, narrow mandates would imply multiple 13 development banks to address a diversity of market failures, which may limit economies of scale, generate coordination problems, and possibly limit the collection and dissemination of information across different economic sectors.13 In any event, once the third condition on financial sustainability is introduced, it becomes problematic to build a successful development bank that satisfies all conditions, even with a well-justified and narrow mandate and no government failures to contend with. The three conditions for a successful development bank tend to contradict each other. In the limit, if the financial sustainability constraint imposed on the development bank means commercial profitability, they generate a virtually impossible trinity. To see why this is the case, let us start by assuming that the government has properly identified a market failure that creates a financial gap that needs to be filled with financial assistance. The first condition for successful development banking is based on the assumption that financial support under appropriate terms is the best way to redress this particular market failure. The second criterion states that development banks should not crowd out the private system but rather expand overall credit, only operating in markets in which the private financial sector does not operate (or where the supply of commercial credit is below the social optimum). But this expansion, even if partially attained, can only happen if the development bank operates at better-than-market conditions, let us say by offering an interest rate that is below the market rate.14 To the extent that private financial markets are competitive and lend at fair rates, meaning rates yielding zero economic profit, below-market rate lending would yield capital losses, thus failing the third requirement for successful development banking. In a nutshell, success would be impossible. There is a caveat, however: under some conditions, lending at below-market rates does not necessarily entail losses to the development bank. One important exception is the case in which the private financial system is not competitive. For example, in poor countries with incipient financial markets, market interest rates can be inefficiently high because commercial banks have monopoly power yielding abnormally high profits. Fair lending by a state-owned bank would entail cheaper loans and may be useful to limit commercial banks’ monopoly power. In this case, the development bank would be a state-owned commercial bank whose role would 13 For instance, Mexico has seven development banks. 14 This encompasses cases in which the borrower has no access to credit and therefore the market rate is infinite. 14 be to foster competition, rather than a development role.15 In this paper we concentrate on the development role and leave out these considerations. Another exception that may make the trinity possible is the case in which the development bank has superior screening technologies or better means of enforcing debt contracts than commercial banks, which would make it able to afford lower lending rates. However, it is not clear why a state-owned bank would be better at screening commercial risks. At the same time, while its public nature may endow it with more powerful enforcement tools, the sociopolitical pressures it may feel to be lenient with debtors make it unlikely that these considerations would salvage the trinity. A more promising alternative is that development banks may be better able to absorb risks and fill some of the gaps left by risk-averse commercial banks.16 For example, if commercial banks fail to provide long-term credit at reasonable terms because of excessive risk aversion, a development bank better able to bear risk can fill this gap without compromising financial sustainability.17 Rudolph (2009) suggests that differences in risk aversion may create opportunities for profitable development banks that do not crowd out private banks, especially in countries with underdeveloped financial sectors. The general conclusion is that it is difficult for a development bank to fulfill a development mandate and be profitable unless the commercial financial system is underdeveloped. While it is clear that the fiscal costs of meeting development objectives need to be minimized, this near-impossible trinity shows that financial self-sufficiency cannot be a condition for successful development banking. In practice, development banks are often given some financial leeway, but are still required to operate under arbitrary financial targets. For instance, de Luna-Martínez and Vicente (2012) show that there are several banks that are required to avoid accounting losses in order to 15 The same reasoning applies to situations in which a specific segment of the capital market is underdeveloped. For instance, Petersen and Rajan (1995) found that banks with monopoly power are more likely to lend to new and credit-constrained firms because they will be able to extract rents from the firms’ future profits. In this setting, an institution like Canada’s CDC, which specializes in lending to new firms but does not maximize profits, can improve access to credit to new entrants without the negative effects of monopoly power. 16 A justification for lower risk aversion comes from Arrow and Lind (1970), who have shown that in public projects the social cost of the risk tends to zero as the population tends to infinity. 17 Similarly, a state-owned bank may be able to internalize the financial benefits of a “big push” while competitive private banks may not. 15 preserve their capital. In this way, capital (adjusted for inflation) is maintained.18 This laxer form of financial sustainability in an economic sense, that ignores the opportunity cost of the bank capital, allows some limited margin for negative economic profits and makes the trinity possible, albeit barely. Development banks often receive explicit or implicit subsidies more substantial than a free capital endowment (for a methodological approach see Schreiner and Yaron, 2001). LunaMartínez and Vicente (2012) found that 40 percent of the institutions included in their survey receive direct government transfers and 64 percent of the surveyed institutions benefit from a government guarantee on their debt. Presumably many other institutions receive less transparent subsidies in terms of tax advantages or access to cheap funding. Looking at the bank’s profitability without accounting for these subsidies is a meaningless exercise. While it is easy to adjust profits when institutions receive direct government transfers, accounting for government guarantees and other types of subsidies is a much more difficult exercise that requires detailed information on the bank’s sources of funds and a judgment on the social cost of funds. The leeway that these development banks get is often not transparent and involves hidden fiscal costs, which negates financial accountability. A further element muddying the waters is crosssubsidization: a bank with a profitable business line (in which it competes unnecessarily with the private system) could use the profits to produce the financial resources it needs to fulfill its policy mandate. There is also the concern that cross-subsidization may weaken the governance of the development bank (Scott, 2007). Even in the cases in which the financial resources constraint is not a straitjacket, development banks are often under pressure to obtain better financial results and praised when they succeed in contributing to the fiscal pot. The emphasis on financial performance makes development banks more concerned with financial strength than with the less tangible development mandate.19 In fact, Holmstrom and Milgrom (1991) show that, in a principal-agent set-up with agents facing multiple tasks and where there are tradeoffs between achieving these tasks, agents will have an incentive to put excessive effort into the task with a clearly measurable 18 This is the case, for example, of Mexico’s Nacional Financiera (NAFIN). In fact, NAFIN’s board targets an average zero real rate of return in an accounting sense. 19 Colby (2013), for instance, claims that BNDES may be too conservative because the development impact of a loan is hard to evaluate but defaults are easy to measure, and employees can be punished for loans that default. Employees end up being too risk averse and, rather than maximizing the Bank’s development impact, they maximize its financial health. 16 outcome and not enough effort into the task with a less clearly measurable outcome. One implication of this result is that when there are tradeoffs between achieving different objectives and at least one of the objectives is difficult to measure, it could be optimal to have limited incentives on all tasks, even on those that are easy to measure. Hence, a development bank which has a target in terms of both financial performance and development mandate may end up privileging the first, easy to measure, objective, possibly at the cost of the second. Imposing tight financial targets on development banks may contain many of the undesirable financial effects of government failures but are blunt devices with detrimental side effects. They may avoid disasters but at the cost of neutering the development bank and eroding its relevance. Our survey confirms the lack of clarity surrounding the appropriateness of development bank funding, an issue that ought to be decided on technical grounds in a transparent fashion as a fiscal concern. Some of the surveyed banks receive explicit subsidies in terms of government transfers or access to below-market funding, while others only benefit from explicit or implicit government guarantees. None of the surveyed banks provided us with hard data on their dependence on explicit or implicit subsidies. In fact, most interviewed bank managers became defensive when asked about subsidies received. Some claimed that their bank does not receive any subsidy. Others said that the financial benefits (in terms of distributed profits or increase in tax revenues) far outweigh the implicit or explicit subsidy received by the bank, but no one appeared to have conducted an assessment of the value of the subsidy. 2.3 Second-Tier Development Banks An alternative idea for controlling government failures that avoids imposing a self-defeating financial straitjacket has been the creation of second-tier development banks. Instead of lending to firms as a regular bank, second-tier development banks use commercial banks as intermediaries. They lend to commercial banks for them, in turn, to provide the financial assistance to the final clients. In this way, many of the functions of the traditional (first-tier) development bank that may be subject to government failure, such as biased or careless screening, inefficient lending operations or lax collection, are eliminated.20 20 De Luna-Martínez and Vicente (2012) found that 12 percent of the institutions covered in their survey operate as second-tier institutions, 36 percent as first-tier, and the remaining 52 percent blends first and second-tier operations. Among the banks that are member of the Association of Latin American Development Banks (ALIDE) 47 percent are first-tier, 34 percent second-tier, and the remaining 19 percent are hybrid institutions. However, ALIDE’s membership includes many commercial banks. 17 Along with financial starvation, deference to commercial banks is another way to contain development banks. The wave of privatization mentioned in the introduction also included the restructuring of many development banks from first tier to second tier.21 Was this transition from first-tier to second-tier development banks a sound idea? Were the new arrangements carefully crafted to foster the public interest? The traditional view maintains that second-tier institutions are often preferable to firsttier institutions because the former are less likely to be subject to political influence, are less demanding in terms of risk-evaluation and management skills, and have lower fixed costs as they do not need to be present in the territory with an extensive branch network. There is evidence that second-tier development banks have lower non-performing loans ratios than their first-tier counterparts because commercial banks tend to be more creditworthy than final beneficiaries (de Luna-Martínez and Vicente, 2012, and Gutiérrez et al., 2011). In summary, second-tier arrangements appear to be effective in reducing government failures. Nevertheless, in the literature there is a debate on the relative merits of first and secondtier institutions, the problem being that in the latter it is more difficult to reach the substantive development objectives of addressing market failures. In order to understand the potential tradeoffs, we need to analyze the differential incentives of public and private sector managers. A good starting point is the Hart, Shleifer and Vishny (1993) analysis of the conditions under which direct state provision of a public service is superior to contracting with private provision. They frame their discussion using a principal-agent model and show that private provision tends to be superior if i) the principal (the state) can write a detailed contract on the characteristics of the good to be provided and ii) if the agent (the private bank manager) has limited opportunities for introducing innovations that, while not violating the contract, can reduce costs by negatively affecting the quality of the good or service. Levy Yeyati, Micco and Panizza (2007) apply the discussion of Hart, Shleifer and Vishny (1993) to the case of banking and conclude that direct provision dominates contracting if and only if the development bank has the capacity to identify projects or sectors that have a high social return and the state cannot write a verifiable detailed contract specifying the corresponding activities for the private bank.22 21 This includes conspicuous examples in Latin America, such as COFIDE in Peru, NAFIN in Mexico and CFN in Ecuador. 22 This formulation abstracts from agency problems within the state. A more detailed analysis would look at how to structure development bank governance in relation to political power. 18 This analysis suggests that the main disadvantage of second-tier development banks is that these institutions do not get to select the end costumers to target the projects with the highest social returns. Commercial banks make that selection and have all the incentives to use cheap public funding to lend to their same low-risk customers, in effect leading to public financing crowding out private financing. Even the best lending guidelines agreed with commercial banks may fail to do a good job in effectively inducing them to make the kind of public-interest lending choices that a development bank intends to make. Furthermore, second-tier development banks need a well-designed system to allocate the subsidized funding they provide across private banks, typically auction mechanisms for banks to compete, so that it fully benefits final borrowers rather than the intermediaries. Our survey confirms the risk that second-tier banks lead to higher interest rates for end customers because intermediary commercial banks capture a share of the subsidy provided by the development bank in their own commercial spread. The dissipation of subsidized funding in the process of intermediation through commercial banks would further reduce the likelihood that additional worthy projects will be funded in the back end. Some managers of second-tier development banks participating in our survey confirmed that operating in that modality may lead to complex principal-agent problems. They mentioned that first-tier commercial banks may try to appropriate the benefits associated with the cheap financing provided by the second-tier development bank. In two interviews it was mentioned that final borrowers have complained that most of the benefits linked to development bank lending programs accrue to first-tier intermediaries. Finally, in another interview it was said that in the country the capital market is geographically segmented and the bank is only effective in geographical areas where first-tier banks face liquidity shortages. A specific region was mentioned where firms are credit constrained because of lack of collateral but banks have plenty of liquidity. The bank (which does not provide guarantees and therefore cannot solve credit constraints problems) does not have customers in this region and therefore does not have any knowledge of specific challenges facing this region. Things are instead different in other regions where first-tier banks apply for second-tier refinancing and where the second-tier bank can also channel funds to credit-constrained firms because of its close cooperation with credit guarantee agencies. 19 2.4 Are Traditional Development Banks Working? The above discussion suggests that the performance of the traditional development bank is poor, or at least unimpressive. Oftentimes, lack of conviction in the role and priorities of development banks leads to containing rather than fostering their activities through narrow mandates, meek deference to commercial banks, and financial starvation. In turn, performance is judged against formal lending goals and arbitrary financial targets rather than development impact. Our survey of eight national development banks based on 11 interviews of current and former authorities, which could be expected to have a rosy view, does not help to change that assessment. In fact, the survey suggests a short answer: “we don’t know,” in itself a damning finding. In most of the interviews (six out of 11) it was revealed that the corresponding banks do not conduct internal or external evaluations of their activities, and in one case that the evaluations conducted by the bank are useless and they only exist formally because donors requested them. In three of the remaining five interviews the managers described their evaluations as restricted to project-level activities (at least in one case originated at donors’ request). In only two of the 11 interviews was it reported that the banks also attempt to evaluate the overall development impact. 3. Smart Development Banks One possible reaction to the findings above is to say that, once financial markets develop, we do not really want to insist on relying on development banks and betting more resources on them. Such a response, however, would leave largely unattended enormous development needs calling for strong financial policies. Such a defeatist reaction would spring from accepting that the limitations and vices of the traditional development bank are insurmountable. By contrast, we suggest that development banks should be redesigned to fulfill their promise. In this regard, we propose the upgrading of the traditional development bank to what we term the smart development bank. Smart development banks incorporate a new intelligence role that will strengthen their ability to contribute to substantial development objectives. 3.1 A New Intelligence Role As mentioned above, the foundational idea that development banks only address well-specified market failures implicitly assumes that the bank’s management has a good understanding of the existing market failures and knows the best way to address them with financial assistance. 20 However, market failures are not directly observable. This is especially so in relation to the structural transformations at the root of economic development, because they involve the creation of new activities that the market fails to bring about, activities that are below the radar. It is not easy to identify the market failures that can be alleviated with development financing. And yet, the traditional paradigm assumes that the government has a great deal of knowledge on the obstacles to economic development that development agencies are called to remove. Specifically, it implicitly assumes that the government: i) has a list of the market failures that hamper economic growth; ii) can rank these market failures in order to decide how to allocate its scarce resources; and iii) knows the best way (grants, lending, guarantees, equity stake, regulation, public provision of missing inputs, etc.) to address these failures. How do policymakers know about the obstacles to the creation of new activities and what activities should be promoted? How do they identify when commercial banks fail to provide financial assistance to projects that yield high return and are worth the risk of financing with public resources? And equally important, how can they recognize meritless operations and credibly make the case that the bank should not be pressured to finance them? In this paper we question the premise that policymakers and decision-makers have the required information to give a clear mandate to development banks. This lack of clarity is largely responsible for what are often half-baked mandates and lending programs that mechanically match them without much regard for a serious consideration of their development impact. Evaluations designed to keep development banks accountable are, when they exist, correspondingly shallow and formulaic. To redress this key knowledge weakness, the Achilles’ heel of productive development policies, we make the case for a new intelligence role of development banks that exploits the complementarities between financial assistance and the design of productive development policies. We start from the observation that banks have a unique vantage point to uncover obstacles to firm creation and growth, for discovering not only market but also government failures impeding economic transformation. Banks are special because they can learn about failures in the process of assisting firms. Notwithstanding the value of academic studies and technical expertise in relevant ministries, direct and continuous exposure with the problems that firms face in the real economy is necessary for carrying out successful productive development policies. Interaction with actual and potential entrepreneurs is necessary to learn about what 21 constrains entrepreneurship from establishing firms. The importance of public-private collaboration for conducting productive development policies is increasingly recognized as a critical factor for success (see Fernández-Arias et al., 2016, for a review of country experiences). We envisage development banks that are able to analyze potential projects with an eye to finding out what is holding them back and actively looking for solutions such as advocating the alleviation of undue impediments and the provision of needed public inputs as well as searching for additional private investing partners to provide missing inputs to structure a successful investment package. A smart development bank would look at the development impact of such solutions considering their systemic impact on other investors and projects beyond the transaction under its consideration. More generally, we propose that it be deployed as an instrument of economic intelligence and play an active role in the design of national productive development policies as well as their implementation in conjunction with the private sector. This new intelligence role of development banks is parallel to the informational function of commercial banks. In fact, financial intermediaries exist precisely because credit is an information-intensive activity and information is costly to collect but easy to reproduce (e.g., Leland and Pyle, 1977). Commercial banks accumulate information relevant to project returns and creditworthiness as they evaluate their applications for new loans and observe firms’ transactions (based on which they can make decisions to outcompete other banks). Being in direct contact with established firms and fledgling entrepreneurs, commercial banks also have a privileged vantage point for identifying failures and possible solutions to these failures. However, it would be difficult to hijack commercial banks’ access to knowledge for this purpose because they do not care about social returns. Furthermore, they can extract profits from keeping the information they acquire in the lending process private and would not be inclined to reveal it. If information is to serve the public interest by discovering high social return opportunities, it will need to be primarily acquired by public entities such as development banks. It makes sense to bundle lending and research because of the complementarities between the two. Through their screening of applications and lending activities, development banks can gather information on: i) what are the business ventures that the private sector is exploring, ii) what type of inputs (e.g., goods, services, skills) pioneering firms need in order to develop and become viable, iii) what are the bottlenecks that affect specific industries, iv) what are the industries that could benefit from the experiences already acquired in other parts of the economy 28 bank operates as a second-tier bank. Nevertheless, some bank managers were more pessimistic than others. At one extreme, one manager said that it is impossible to obtain good information from first-tier partners because these private banks are only trying to maximize short-term profits and do not care about the medium and long run. Another manager said that things work well when the development bank cooperates with investment banks in infrastructure financing but that it does not obtain any information when it lends to firms through first tier banks. Six bank managers were less drastic and said that, when their institutions operate as second-tier banks, they do obtain some information about the ultimate borrowers (see KfW’s discussion in Appendix B). However, they admitted that there is a substantial loss of information with respect to first-tier banks. Finally, two bank managers said that they have a good system for sharing hard information with the first-tier banks with which they operate but that, nevertheless, they do lose the soft information that comes from continuous contact with ultimate borrowers. Of course, there is still a trade-off between first and second-tier arrangements: benefits in terms of information gathering in a first-tier smart development bank might be outweighed by political failures and poor managerial capacity in the public sector. In some circumstances it may be worthwhile to think about mixed institutional arrangements that retain the informational advantage of first-tier arrangements but can address some of these political and managerial failures. In what follows we discuss some ideas for hybrid arrangements. Problems related to poor risk evaluation and political capture in lending could be attenuated by requiring that first-tier development banks enter into (subsidized) co-financing arrangements with commercial banks, so that they need to find a commercial bank partner to complete an operation. In this way, loan eligibility and pricing would be vetted by the market, thus constraining biased or careless lending.25 Alternatively, the development bank could be required to sell its loans to commercial banks after a pre-specified period of incubation. Such scheme would generate incentives to carefully select these loans (bad loans will reveal their poor quality by being less valuable) and, by exonerating the development bank from the onerous task of collecting loans or enforcing collateral, they could benefit from the superior credit enforcement ability of commercial banks (in certain institutional environments, public banks 25 In fact, one manager in our survey said that co-financing arrangements with private banks are an ideal setting for exploiting the complementarities of public and private sector financial institutions. Armendariz de Aghion (1993) also discusses the merit of co-financing; however, in her model it is the development bank that transfers knowledge to the private bank 29 may face political obstacles in collecting loans and enforcing collateral). In fact, these have been some of the traditional reasons for privatizing state-owned companies. Privatizing collection in this hybrid structure may solve this problem while retaining the informational value of a first-tier arrangement. 4. How Ready Are Development Banks to Play the New Role? This section summarizes the results of our survey of managers of eight national development banks, replying either individually or as a group. In the case of group interviews, we considered the prevalent view in each group; in our reporting, we refer to the view expressed in each interview as the view of one manager. In the case of three of the eight development banks we also surveyed past authorities, so that the survey encompassed 11 structured phone interviews or “managers.” The survey focused on the desirability and feasibility of the intelligence role of development banks described in this paper. By and large, responses support the idea that the advancement of an intelligence role in development banks is valuable and promising but needs political and financial backing to make it happen. Bank managers’ feedback was almost unanimous (10 out of 11) in saying that development banks can be ideal tools for providing economic intelligence of the kind described in this paper. However, only two of the 10 expressing favorable opinions are satisfied with the way their institutions are advancing an intelligence role (BNDES and KfW). They said that their institutions have a structured system for collecting and analyzing information and providing inputs to the design of economic policies (see Appendix B for a discussion of these two cases). This suggests that there is fertile ground to advance in this direction in most development banks. In fact, of the remaining eight favorable opinions for incorporating an intelligence role that are dissatisfied with the status quo, two managers were drastic: despite agreeing with the ideas discussed in this paper, they stated that their banks do not play any economic intelligence role whatsoever. Both of them said that it was because of lack of resources, but one manager also mentioned that his bank does not have a sufficiently good relationship with the government. According to this particular bank manager, his government is not interested in receiving policy advice from the bank. This manager added that there are no well-established communication channels between the government and the development bank and that some ministries are implementing policies that compete with the activities of the development bank without proper 30 consultation. Specifically, the government has no idea of what the bank does, and the bank management has no idea of what the government wants from the bank. This manager felt that the government was more of a competitor or an obstacle than a partner. The other six dissatisfied managers said that intelligence is not collected and organized systematically, and that the transmission of information to the government is done through informal channels. This situation is partly due to lack of resources but also linked to the fact that the bank does not have a clear intelligence mandate and managers feel that they will not be evaluated on the basis of the policy advice they provide. One of these managers said that the bank does have a research department but that the department does not use information generated within the bank. The department’s main objective is to inform bank staff and management about research that is conducted outside the bank (in universities, think tanks, international organizations, and central banks). The same manager also said that, while the bank does not collect data, lending decisions are sometimes based on data collected by the national statistics agency. According to this manager, the current system allows the bank to serve established enterprises but is not helpful for identifying new promising enterprises that need seed capital. The experience of the managers responding that their institutions are doing something concerning an intelligence role offers some interesting insights. One manager said that the bank was in the process of developing a system for collecting and transmitting information to the government. This manager also said that regular consultations with entrepreneurs located in different regions are a good instrument for understanding the challenges faced by both new and well-established firms.26 Many managers said that their banks are trying to have a better grasp of what is happening outside the capital city by holding regional consultations and by having more people in the field. One obstacle to this strategy relates to the fact that the government does not always appreciate the potential long-run benefits of such a policy and may thus penalize bank managers that incur the short-run financial costs associated with decentralization. This is a symptom of a more generalized problem related to the fact that performance evaluations are often based on short-term outcomes. One manager said that all development banks should have a research department that interacts with the operational departments with the ultimate objective of generating economic intelligence for the bank and the government. When asked about the financing of the research 26 In his view it was important to consult with individual entrepreneurs rather than with entrepreneurial associations. 31 department, the same manager stated that financing through fiscal transfers would maximize transparency but risk making the research activity subject to political pressure and lead to volatile budgetary resources. This manager concluded that is probably better to finance the research department with the bank’s own revenues. Another manager suggested that there are economies of scale in the design of institutional procedures that would allow development banks to play the intelligence role described in this paper. This manager thought that development banks that operate in different Latin America countries could learn from each other and that the IDB could act as coordinator and lead an initiative aimed at developing systems for collecting information that can be shared and compared across countries. This would be an important regional public good. The manager also said that governments that are skeptical about the role of development banks could become more willing to empower their own development banks if they were exposed to successful experiences in other countries. In discussing how banks can learn from lending, one manager described a case in which his bank was asked by the government to rescue a cooperative firm that had lost access to credit. At the beginning, this was pure political lending. The only objective of the government was to avoid job losses. However, by working with this cooperative, the bank acquired substantial knowledge about financial challenges that are specific to cooperative firms and this knowledge is now allowing the bank to lend to cooperative firms, which are usually ignored by private banks. In fact, crises seem to increase the leverage of development banks. In another example, a manager mentioned that his bank was able to acquire detailed information about the production process and financial linkage of an important sector of his country’s economy only when the sector found itself overexposed to commercial banks and the bank had to step in to rescue both banks and producers. Another manager said that the second-tier bank was able to create a dialogue between farmers, suppliers and first-tier banks which allowed the bank to gain a better understanding of the value chains in the agricultural sector and formulate well-targeted credit lines. This manager said that, at the beginning, the various counterparts were not willing to share information and that the program was successful only because the bank was seen as an impartial institution and because it had some leverage on first-tier banks. 32 One bank manager stated that there could also be learning from projects that are not financed. For instance, about 30 percent of projects belonging to a specific line of credit (renewable energy sector) that were positively evaluated by an initial feasibility studies ended up not being implemented (hence, not financed). The same manager said that the bank should have tried to understand why these projects were not implemented. Last but not least, as mentioned before, of the 11 bank managers, there was one who responded that it is not desirable to mix lending with policy advice and that the ideas discussed in this paper are not well suited for his/her bank and for the institutional environment in which the bank operates. The manager said that the information collected and analyzed by the development bank is not different from the type of information collected and analyzed by private banks and that the development bank does not have the mandate or budget to collect and analyze information that go beyond capacity to pay. The manager added that it would not be appropriate to disseminate this type of information to third parties, not even to the government who owns the bank, because close interaction with the government would have more costs than benefits. In particular, the manager thought that closer ties with the government would limit the independence of bank managers, push the bank towards politicized lending, and ultimately lead to large losses for the bank. The same bank manager also mentioned that information does not flow well even within the bank and that it would be difficult to share knowledge with parties outside the bank. While there are informal channels through which bank managers discuss the country’s main policy challenges with government officers (both at the national and local level), this particular manager does not think that it would be a good idea to formalize these channels of communication. The manager said that formal policy discussions would lead to political pressures for credit allocation and concluded that credit allocation and dissemination of information should not be mixed. 5. Conclusions The traditional paradigm of development banks is that these institutions should target market failures that can be addressed with financial assistance at appropriate terms (while abstaining from distorting markets by competing with private banks). In this paper, we argue that the implementation of this paradigm has the fundamental problem of assuming that market failures and the corresponding policy solutions are well-identified, while in practice they are not because 33 the required learning mechanisms to ascertain them are usually not in place. Our evidence-based analysis shows that, in practice, the paradigm is often undermined by lack of confidence on the bank’s ability to redress market failures, leading to containing rather than fostering its activities through narrow and formulaic mandates, deference to commercial banks and starvation of required subsidized funding. In the extreme, development banks are neutered by a financial straitjacket and/or second-tier arrangements are captured by first-tier commercial banks. In this paper, we argue that a key reason why development banks fail their critical development purpose is lack of clarity on the market failures that need to be addressed. We ask: given that market failures are not observable, how does the government obtain this information? Discovering market failures and how to redress them requires field exposure, public-private collaboration, and a learning mechanism to establish policy. Rather than abandoning the promise of development banks as strategic instruments, we suggest that we should instead rethink development banks and redesign their operations to exploit the complementarities between lending and the design of productive development policies. We propose the establishment of smart development banks. We start from the observation that first-tier development banks have a unique vantage point for observing market failures and uncovering obstacles to firm creation and firm growth. 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For instance, the Productive Development Policies (PDP) program implemented by President Lula led BNDES to work closely with the high-tech sector and allowed the Bank to gain a better understanding of what niches are well suited for Brazilian firms. This, in turn, allowed the Bank to fine-tune its lending strategy and provide the government with inputs for the implementation of the PDP program. BNDES also manages some venture capital funds that, besides being profitable, give the bank a unique opportunity to participate in the management of new firms and gain a better understanding of the challenges and opportunities faced by new firms. Along similar lines, BNDES provided key inputs for the design of Plano Brasil Mayor (PBM) implemented by President Dilma Rousseff. For instance, the government wanted to promote the use of national content in the production of capital goods, and BNDES was able to implement this policy because it had good knowledge of production process and therefore could evaluate the national content of various capital goods. (This does not mean that the government policy is necessarily good, but the bank has the capacity to implement the policy) When asked whether the structure described above is replicable in smaller development banks, BNDES management replied that size does not really matter and mentioned that most of the research is conducted within the sectorial departments, which often have less than 40 employees. According to BNDES management, the organizational structure is more important than overall size. There is an issue related to the fixed costs involved in creating a system for organizing and analyzing different sources of information, but that system does not necessarily need to be country-specific. Development banks located in different countries could possibly share this fixed cost and learn from existing experiences. BNDES has both formal and informal channels for communicating with the government. BNDES staff members have a strong reputation in Brazil, and government officers often have informal contacts with BNDES to seek staff opinions and views on a wide variety of policy and technical issues. Bank employees are often consulted by central and local governments not only because their job gives them a privileged vantage point but also because of their technical and 45 analytical skills. In fact, one bank manager said that the government virtually delegated certain industrial policy tasks to his bank because of organizational advantages linked to the presence of well-qualified staff. At the formal level, BNDES management has seats in various ministeriallevel government committees that provide inputs to the design of the Brazilian industrial and economic policy. Specifically, in Brazil industrial policy is organized along 19 sectors (and multiple themes) and BNDES has representatives in each of the 19 competitiveness committees in charge of designing sector-specific policies. Six of those 19 committees are chaired and coordinated by BNDES staff (the other 13 by different ministries). While operating in an economic and institutional environment that is very different from the one faced by BNDES, the German development bank KfW is also actively engaged in advising the German government on how to achieve its economic development goals. KfW operates as a second-tier bank. The fact that KfW has no direct contact with the ultimate borrowers does not allow the Bank to collect soft information on its ultimate borrowers. However, KfW has substantial leverage on its first-tier counterparts, and this leverage allows KfW to collect data on all German small and medium enterprises (SMEs) that have accounts with first-tier banks that receive KfW second-tier funding. This dataset covers more than 100,000 SMEs and, besides standard indicators on capacity to pay, includes information that makes it possible to forecast future production and to evaluate some of the constraints faced by German SMEs. In collecting these data, KfW is especially concerned with understanding the constraints faced by firms that want to adopt new technologies. KfW also collects extensive data on start-up firms. KfW is also active in all sectors related to the green economy. This is a sector in which the bank has a vast amount of information due to the fact that KfW is the main market maker in emission trading in Germany. KfW uses these data to guide its own lending strategy and to provide advice to German policymakers, but it also produces (in cooperation with various German think tanks) periodical reports which are freely available on the bank’s website. While KfW’s research activity was originally fully financed with the bank’s general budget, research now generates a substantial amount of own resources because KfW sells a large number of indicators and analyses that are then sold to the German federal and regional governments and to Eurostat. 46 There are many channels through which KfW provides inputs to the design and implementation of economic policy in Germany. First, KfW shapes policy by implementing its own mandate. For instance, as KfW has a mandate of promoting the green economy, KfW staff interacts with the government to design policies that focus not only on KfW’s financial activities but also on complementary actions that the government can take to promote the green economy. Second, KfW staff and management often support and provide advice to government officers who conduct bilateral negotiations with the private sector. Finally, KfW staff and management participate in advisory meetings with the Ministry of Finance and the regional governments with the specific objective of providing inputs to the design of federal and regional economic policies.