## _wp07227 - Introduction: Access to Finance and Public Policy

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---

### A. Access to Finance
- Definition: opportunity for individuals and firms to use, at a fair cost, financial system instruments that facilitate personal and commercial economic transactions, such as:
  - Credit instruments;
  - Insurance (hedging) instruments; and
  - Savings, payment, and remittance instruments.
- Benchmark: ideal Modigliani-Miller world where all worthwhile (positive net present value (NPV)) projects can be financed, subject to restrictive assumptions (perfect information, complete contracts, costless enforcement, complete and efficient markets, no transaction costs, taxes, or bankruptcy costs).
- Reality: access to finance is always imperfect because the restrictive assumptions do not hold.
- Two major concerns:
  - Cross-country inequality (insufficient financial depth): developing countries typically have access to a narrower range of financial instruments.
  - Within-country inequality (insufficient financial breadth): wealthier individuals and larger established firms typically have better access than the middle class, SMEs, poor individuals, and micro enterprises.
- Determinants: access is deeper and wider under better institutions (transparency, property rights) and less distortionary environments; recent literature highlights institutional factors such as transparency and contracting environment.

### B. Fundamental Policies
- Public policy objective: deepening and broadening financial access to support economic growth, financial stability, and social justice.
- Principal institutional dimensions:
  - Well defined commercial property rights, including:
    - Effective contract enforcement;
    - Collateral pledging and claiming mechanisms;
    - Bankruptcy procedures; and
    - Investor protection and corporate governance systems.
  - An environment that fosters transparency, including adequate accounting principles and credible disclosure mechanisms.
- Principal financial system dimensions:
  - Efficient financial regulation and supervision;
  - Ownership structure of financial institutions, reflecting:
    - A clear and focused role for state financial institutions, if they exist;
    - The degree of foreign ownership reflecting country-specific benefits and costs;
    - Controls on negative effects of bank-industry cross-ownership.
  - Entry and competition policy balancing entry opportunities with preserving charter value.
  - Crisis resolution tools: deposit insurance, liquidity support mechanisms, effective financial institutions bankruptcy procedures.
  - Financial infrastructure: payments system and credit databases.
- Implementation caveats:
  - Fundamental reforms may have very long gestation periods; governments may need transitory solutions.
  - Market failures that may require targeted interventions include:
    - Insufficient collateral endowment of agents;
    - Lack of statistical information (e.g., credit histories) for agents with historically low economic activity or in volatile economies;
    - Incomplete, illiquid, or not deep enough markets;
    - Underinvestment in financial infrastructure or public financial literacy due to coordination problems and sunk costs;
    - Underinvestment in industries exhibiting positive externalities.
  - Political resistance and capture by economic incumbents can block or subvert reforms, sometimes producing policies that benefit established interests rather than expanding access.

### C. Public Provision of Financial Services
- Rationale: when fundamental policies fail due to long gestation, market failures, or political opposition, governments may provide missing financial services as transitory or targeted interventions.
- Practical limitations and risks of public provision:
  - Governments may be influenced by special interests and limited by bureaucratic incentive structures.
  - Major problems include:
    - Distortionary, excessive, or improperly designed interventions from political pressures or bureaucratic incentives;
    - Inefficiencies such as politically connected lending to allies or “national champions”;
    - Entrenchment and reluctance to downsize, reform, or liquidate when markets can take over, creating vested interests that preserve rents;
    - Delay of necessary fundamental reforms as transitory solutions reduce pressure for change, potentially increasing future adjustment costs.
- Net effect: ambiguous — public interventions can provide welfare-improving transitory solutions or correct market failures, but practical government failures can be more distortionary than market shortcomings.
- Regulatory stance: government should act only if it can address economic imperfections better than the market.

### D. Regulatory Perspective
- Public financial institutions are important globally, present even in developed countries.
- Creation or liquidation of public financial institutions is typically a political decision; regulators often treat that decision as given and focus on how to respond.
- Regulatory objectives when such institutions exist:
  - Maximize benefits of enhanced financial access while acknowledging and containing potential costs and risks.
  - Contribute to public discussion on rationale and optimal design where possible.
- Challenges for regulation and supervision:
  - Public institutions often have significant systemic, fiscal, and economic policy importance.
  - Common weaknesses: lack of market discipline, low profitability, owner and managerial myopia, mismanagement risks, and high chance of regulatory forbearance induced by political pressures.
  - Regulators need sufficient (international) evidence distilled to best practices to perform adequately.

### E. Study Scope and Method
- Sample: 18 public financial institutions from five G10 countries—Canada, Germany, Japan, United Kingdom, and United States.
- Focus sectors: housing, SMEs and innovative firms, and agriculture.
- Empirical examination covers three dimensions of public financial interventions:
  - Rationale: whether the declared or understood rationale is valid, outdated, excessive, or wrongly designed/implemented.
  - Organization: financial instruments provided, financing mechanisms, profitability, and ownership.
  - Oversight: how government exercises control rights through governance structures (CEO and board appointments) and external regulation and supervision; derivation of best practices for governance and regulation of public financial institutions.
- Sample institutions include:
  - United States: Housing—Fannie Mae/Freddie Mac, Federal Home Loan Banks; SME/Innovation—Small Business Administration Credit Guarantees Program; Agriculture—Farm Credit System.
  - Canada: Housing—Canada Mortgage and Housing Corporation; SME/Innovation—Business Development Bank of Canada, Canada Small Business Financing Program; Agriculture—Farm Credit Canada.
  - United Kingdom: SME/Innovation—Small Firms Loan Guarantee Program, High Technology Fund / Regional Venture Capital Funds.
  - Germany: KfW, Foerderbank, Mittelstandsbank.
  - Japan: Housing—Japan Housing Loan Corporation; SME/Innovation—National Life Finance Corporation, Japan Finance Corporation for Small and Medium Enterprise, Shoko Chukin Bank, Development Bank of Japan; Agriculture—Japan Agriculture Finance Corporation.
- Main findings (reading of evidence):
  - Public financial institutions in developed countries may have unclear or outdated economic rationales, be entrenched and inefficient, distort rather than complement markets, and be potential sources of significant systemic and fiscal risks — a strong caution for the developing world where accountability and institutional capacity may be weaker.
  - Dominant trends in organization and regulation of government financial services are identifiable and can serve as reference points, but may not be directly adoptable in developing countries, which may require different arrangements given lower regulatory capacity, lagging institutions, and less accountable governments.
- Paper organization: Table 2 summarizes characteristics of the sample on key dimensions; Sections II–IV address rationale, organization, and oversight in more detail.

### Section V — Rationale of Public Financial Institutions: Key points
- All surveyed institutions cite market incompleteness, market failures, or externalities as the basis for intervention.
- Housing finance:
  - Market failures: mismatch between demand for long-term fixed-rate mortgages and banks financed by demandable deposits creates liquidity risk and interest rate risk.
  - Hedging depends on market development: short-term bridge borrowing requires deep money and bond markets; interest rate swaps require developed interest rate derivatives markets; long-term bank borrowing requires developed private pensions or life insurance sectors.
  - Mortgage credit risk can be systematic, amplified by correlated house prices and business cycle co-movement.
  - Social housing: preferential financial access may be used for welfare objectives in some countries (e.g., Canada).
- SME and innovation finance:
  - SME market failures: lack of collateral, credit history, and high transaction/agency costs can trap creditworthy SMEs.
  - Innovation finance requires depth and coordination across early-stage financiers, later-stage investors, and exit markets (IPOs/mergers).
  - Positive externalities: SMEs and innovative firms generate employment and technology spillovers.
- Community finance:
  - Deficient access in remote/poor regions due to lack of community-specific statistical information and capital drain.
  - Typical public responses include Sparkassen/Landesbanken (Germany) or directed schemes like the U.S. Community Reinvestment Act.
- Agriculture:
  - High systemic and catastrophic risks (low crop yields, disease), low profitability, long gestation periods; markets may undersupply credit, especially to small/family farmers.
  - Externalities and need for universal rural coverage justify interventions in some cases.
- Validity of rationales:
  - Some rationales may be outdated or excessive. Housing finance historically justified public involvement but today may be largely served by developed markets except for social housing.
  - Public housing programs in the U.S. account for about 40 percent of GDP in government-sponsored lending and guarantees; in Canada, Germany, and Japan the figure is in the region of 7 percent to 10 percent of GDP.
  - SME finance programs, if improperly targeted (e.g., lending to medium-sized or larger firms), can crowd out private credit and create inefficiencies.

### Organization and Financial Instruments
- Six distinct instruments identified:
  - Direct lending to ultimate borrowers.
  - Intermediated lending to private lenders earmarked for target sectors.
  - Public securitization—purchasing loan portfolios.
  - Guaranteed market securitization—guaranteeing LBS/MBS.
  - Credit guarantees on private loans and securities issuance.
  - Market liquidity provision—public portfolio investments to deepen markets.
- Trade-offs:
  - Intermediated finance outsources screening/monitoring to private lenders and can foster market development; direct lending may be justified for universal coverage or synergies with nonlending services.
  - Intermediated lending can create agency problems; mitigation tools include caps on lending/guarantees, periodic reviews with performance-based bonuses/sanctions, and “smart subsidies” (ex-post grants to repaying borrowers).
  - Guarantees engage private lenders and initially avoid public cash outlays but can encourage lax underwriting and obscure fiscal risks; empirical scarcity of risk assessments for guarantees is noted.
- Recent trends:
  - Public institutions increasingly provide mezzanine and equity-type instruments (e.g., BDBC, KfW Foerderbank, Regional Venture Capital Funds in the U.K.).
  - Venture capital exposure is risky: BDBC reported losses in five out of seven years, with maximum loss of 20 percent of investment in 2002/03.
- Directed lending (outside study) can act as an implicit tax on banks and may compromise intermediary soundness.

### Financing, Subsidization, and Ownership
- Typical financing: borrowing from financial markets; markets perceive implicit guarantees even when not explicit.
- Japan example: Fiscal Investments and Loan Fund (FILP) issues government-guaranteed bonds to fund public lenders at policy-adjusted market rates (mechanism noted as under reform).
- Subsidization:
  - Many public lenders are formally intended to break even but enjoy implicit subsidies via preferential market access, sometimes tax breaks and simplified regulation.
  - Implicit subsidies arise from guarantees; these lower measured profitability but reflect social lending to less creditworthy borrowers.
- Credit guarantee programs:
  - Target smallest firms lacking collateral; commonly loss-making and explicitly subsidized.
  - Observed loss measures vary from 2.6 percent of lending in Canada to 35 percent of loans that default in the U.K.
- Ownership structures in sample:
  - Wholly government-owned, nonprofit corporations (most common).
  - Programs within executive departments (smaller, narrow focus).
  - U.S. examples of privately-owned, publicly-chartered entities: Fannie Mae and Freddie Mac (private for-profit), Federal Home Loan Banks and Farm Credit System (private bank-owned cooperatives).
  - Shoko Chukin Bank (Japan) as joint public-private with government majority (planned privatization).
- Risks of private co-ownership: option value of government guarantees can incentivize private owners to seek rents via socially inefficient expansion.

### Oversight, Prudential Requirements, and Challenges
- Need for strong oversight:
  - Arguments for more stringent oversight prevail because public institutions often face higher and less diversifiable risks, worse managerial incentives, and potential systemic/fiscal consequences upon distress.
  - Public financial institutions resemble “too-big-to-fail” banks; preventive supervision with continuous on-site teams is suggested by analogy.
- Oversight in practice:
  - Multiple administrative oversight layers exist in some systems (e.g., Canada: ministries, central agencies, external auditors, Auditor General special examinations every five years).
  - Corporate governance: governments commonly appoint CEOs and Boards; Boards may include public officials, industry representatives, or independent directors.
  - Routine external financial supervision is generally lacking in sample institutions; none is fully supervised by the principal financial sector supervisor. Japan: annual reports submitted but not subject to routine inspections.
  - Dedicated supervision exists in the U.S. (Office for Federal Housing Oversight; Federal Housing Finance Board); benefits versus mainstream supervision are ambiguous.
  - Shared supervision (financial regulator + ministry in charge) creates enforcement distribution challenges and potential conflicts.
- Capital and prudential requirements:
  - Majority of studied public financial institutions do not have capital requirements; some voluntarily comply (Canada, Germany); Fannie Mae, Freddie Mac, Federal Home Loan Banks have significantly lower capital requirements.
  - Interpretation: government guarantees substitute for capital cushions—reducing market discipline but obviating some capital functions.
  - Risks of substitution:
    - Fiscal risks often unmeasured; contingency planning lacking.
    - Guarantees lack automatic limits on expansion that capital requirements impose, creating incentives for activity growth.
  - Recommendation stance: capitalization is advisable as a default solution over guarantees.
- Governance and transparency challenges:
  - Within-government conflicts of interest between owner and supervisor.
  - Political pressures can compromise supervisor independence.
  - Lack of market discipline reduces price signals for regulators.
  - Many boards lack independent representation; industry representatives can favor expansion. Japan’s managerial boards often lack outside membership.
  - Simplified accounting/disclosure is common but may reduce transparency; need for greater disclosure of financial performance, risk assessments, and policy objective achievement is emphasized.

### Key Findings and Policy Implications (summary)
- Focus and narrow mandates:
  - Public financial institutions should be narrowly focused on verified market failures to minimize market distortion, reduce vested interests, and facilitate reform or downsizing.
  - Narrow focus aids transparency, oversight, and limits to activities that crowd out private sector.
- Oversight principles (summary direction):
  - Supervision should be at least as stringent as for private banks due to higher risks and fiscal exposure.
  - Consider preventive supervision practices used for TBTF banks.
  - Prefer capitalization over reliance on implicit guarantees; where guarantees exist, quantify fiscal exposures and establish contingency plans.
  - Increase disclosure of risk assessments and performance vis-à-vis policy aims.
  - Use intermediated finance by default unless clear case for direct lending exists; use guarantees cautiously with strict underwriting controls and monitoring.
  - Apply mitigants to agency problems in intermediated finance: caps, periodic performance reviews, and carefully designed smart subsidies.
- Fiscal accountability:
  - Make government exposures explicit where possible; adopt explicit guarantees as default for accountability.
  - Measure and plan for potential fiscal costs of large, undiversified sectoral exposures (e.g., housing).

### 1. An effective legal and regulatory framework — Major themes and recommendations
- Major themes from the analysis:
  - Ten Principles for the Effective Supervision of State-Owned Financial Institutions derive from the Basel Core Principles of Banking Supervision and emphasize: regulator’s independency, ability to oversee capital adequacy, disclosure, and risk-management practices, and enforce corrective measures if necessary.
  - The substitutability between regulation / supervision and corporate governance mechanisms in controlling performance of public financial institutions.
  - Transparency of public financial institutions is currently lacking and difficult to achieve due to limited market discipline.
  - Different financial and institutional jurisdictions can lead to divergence of optimal oversight structures; developing countries may benefit from maintaining robust external regulation and supervision in addition to strengthening governance mechanisms.
- Contributions to future best-principles for oversight:
  - Principles should reflect substitutability between regulation/supervision and corporate governance mechanisms.
  - Principles should put maximum emphasis on transparency of public financial institutions.
  - Principles should clearly address issues of differing financial and institutional jurisdictions and the resulting divergence of optimal oversight structures.
  - In particular, developing countries may benefit from keeping a more robust external regulation and supervision approach to public financial institutions in addition to strengthening governance mechanisms.
- Key findings from the sample:
  - Sample studied: 18 public financial institutions in developed countries.
  - Public intervention can correct genuine financial market failures; some examples of well-designed public interventions exist.
  - Many studied institutions suffer from inefficiencies apparently stemming from the excessive scope of intervention.
  - Some institutions’ activities may be wasteful, distortionary, and pose risks to the stability of the financial system.
  - Explicit or implicit government guarantees constitute contingent public expenditures and effectively transfer risks to the taxpayers.
  - Some institutions in the sample suffer from weak accountability and oversight arrangements; reforms may be compromised by pervasive entrenchment.
- Policy implications and recommendations:
  - Reasons for actual or presumed credit market failures should be examined closely before expanding public involvement in financial markets.
  - Analysis should focus on addressing market failures with more “market-friendly” and long-term market development policies, such as better regulation, improved property rights, higher transparency.
  - In case of doubt, countries may be better off foregoing public development banks altogether, or at least should seek to minimize their scope.
  - More investment is warranted and necessary in accumulating evidence and formulating best practices in the organization and oversight of public financial institutions.
- Additional consideration:
  - Reliance on public banks may have consequences for the conduct of monetary policy: when credit is intermediated under artificial (nonmarket) interest rates, this may hamper the normal transmission mechanism.

*Source: _wp07227 - Introduction: Access to Finance and Public Policy (PDF chapter).*

### Introduction: Access to Finance and Public Policy ...................................................................3

### _wp07227 - Introduction: Access to Finance and Public Policy

### A. Access to Finance
- Definition: opportunity for individuals and firms to use, at a fair cost, financial system instruments that facilitate personal and commercial economic transactions, such as:
  - Credit instruments;
  - Insurance (hedging) instruments; and
  - Savings, payment, and remittance instruments.
- Benchmark: ideal Modigliani-Miller world where all worthwhile (positive net present value (NPV)) projects can be financed, subject to restrictive assumptions (perfect information, complete contracts, costless enforcement, complete and efficient markets, no transaction costs, taxes, or bankruptcy costs).
- Reality: access to finance is always imperfect because the restrictive assumptions do not hold.
- Two major concerns:
  - Cross-country inequality (insufficient financial depth): developing countries typically have access to a narrower range of financial instruments.
  - Within-country inequality (insufficient financial breadth): wealthier individuals and larger established firms typically have better access than the middle class, SMEs, poor individuals, and micro enterprises.
- Determinants: access is deeper and wider under better institutions (transparency, property rights) and less distortionary environments; recent literature highlights institutional factors such as transparency and contracting environment (see Levine (2005) as referenced in source).

### B. Fundamental Policies
- Public policy objective: deepening and broadening financial access to support economic growth, financial stability, and social justice.
- Principal institutional dimensions:
  - Well defined commercial property rights, including:
    - Effective contract enforcement;
    - Collateral pledging and claiming mechanisms;
    - Bankruptcy procedures; and
    - Investor protection and corporate governance systems.
  - An environment that fosters transparency, including adequate accounting principles and credible disclosure mechanisms.
- Principal financial system dimensions:
  - Efficient financial regulation and supervision;
  - Ownership structure of financial institutions, reflecting:
    - A clear and focused role for state financial institutions, if they exist;
    - The degree of foreign ownership reflecting country-specific benefits and costs;
    - Controls on negative effects of bank-industry cross-ownership.
  - Entry and competition policy balancing entry opportunities with preserving charter value.
  - Crisis resolution tools: deposit insurance, liquidity support mechanisms, effective financial institutions bankruptcy procedures.
  - Financial infrastructure: payments system and credit databases.
- Implementation caveats:
  - Fundamental reforms may have very long gestation periods; governments may need transitory solutions.
  - Market failures that may require targeted interventions include:
    - Insufficient collateral endowment of agents;
    - Lack of statistical information (e.g., credit histories) for agents with historically low economic activity or in volatile economies;
    - Incomplete, illiquid, or not deep enough markets;
    - Underinvestment in financial infrastructure or public financial literacy due to coordination problems and sunk costs;
    - Underinvestment in industries exhibiting positive externalities.
  - Political resistance and capture by economic incumbents can block or subvert reforms, sometimes producing policies that benefit established interests rather than expanding access.

### C. Public Provision of Financial Services
- Rationale for public provision: when fundamental policies fail due to long gestation, market failures, or political opposition, governments may provide missing financial services as transitory or targeted interventions.
- Practical limitations and risks of public provision:
  - Governments may be influenced by special interests and limited by bureaucratic incentive structures.
  - Major problems include:
    - Distortionary, excessive, or improperly designed interventions from political pressures or bureaucratic incentives;
    - Inefficiencies such as politically connected lending to allies or “national champions”;
    - Entrenchment and reluctance to downsize, reform, or liquidate when markets can take over, creating vested interests that preserve rents;
    - Delay of necessary fundamental reforms as transitory solutions reduce pressure for change, potentially increasing future adjustment costs.
- Net effect: ambiguous — public interventions can provide welfare-improving transitory solutions or correct market failures, but practical government failures can be more distortionary than market shortcomings.
- Regulatory stance: government should act only if it can address economic imperfections better than the market.

### D. Regulatory Perspective
- Public financial institutions are important globally, present even in developed countries.
- Creation or liquidation of public financial institutions is typically a political decision; regulators often treat that decision as given and focus on how to respond.
- Regulatory objectives when such institutions exist:
  - Maximize benefits of enhanced financial access while acknowledging and containing potential costs and risks.
  - Contribute to public discussion on rationale and optimal design where possible.
- Challenges for regulation and supervision:
  - Public institutions often have significant systemic, fiscal, and economic policy importance.
  - Common weaknesses: lack of market discipline, low profitability, owner and managerial myopia, mismanagement risks, and high chance of regulatory forbearance induced by political pressures.
  - Regulators need sufficient (international) evidence distilled to best practices to perform adequately.

### E. Study Scope and Method
- Sample: 18 public financial institutions from five G10 countries—Canada, Germany, Japan, United Kingdom, and United States.
- Focus sectors: housing, SMEs and innovative firms, and agriculture.
- Empirical examination covers three dimensions of public financial interventions:
  - Rationale: whether the declared or understood rationale is valid, outdated, excessive, or wrongly designed/implemented.
  - Organization: financial instruments provided, financing mechanisms, profitability, and ownership.
  - Oversight: how government exercises control rights through governance structures (CEO and board appointments) and external regulation and supervision; derivation of best practices for governance and regulation of public financial institutions.
- Sample institutions (as presented in source Table 1) include, by country and sector:
  - United States: Housing—Fannie Mae/Freddie Mac, Federal Home Loan Banks; SME/Innovation—Small Business Administration Credit Guarantees Program; Agriculture—Farm Credit System.
  - Canada: Housing—Canada Mortgage and Housing Corporation; SME/Innovation—Business Development Bank of Canada, Canada Small Business Financing Program; Agriculture—Farm Credit Canada.
  - United Kingdom: SME/Innovation—Small Firms Loan Guarantee Program, High Technology Fund / Regional Venture Capital Funds.
  - Germany: KfW, Foerderbank, Mittelstandsbank (across housing, SME/innovation, agriculture roles as indicated).
  - Japan: Housing—Japan Housing Loan Corporation; SME/Innovation—National Life Finance Corporation, Japan Finance Corporation for Small and Medium Enterprise, Shoko Chukin Bank, Development Bank of Japan; Agriculture—Japan Agriculture Finance Corporation.
- Main findings (reading of evidence):
  - Public financial institutions in developed countries may have unclear or outdated economic rationales, be entrenched and inefficient, distort rather than complement markets, and be potential sources of significant systemic and fiscal risks — a strong caution for the developing world where accountability and institutional capacity may be weaker.
  - Dominant trends in organization and regulation of government financial services are identifiable and can serve as reference points, but may not be directly adoptable in developing countries, which may require different arrangements given lower regulatory capacity, lagging institutions, and less accountable governments.
- Paper organization: Table 2 summarizes characteristics of the sample on key dimensions; Sections II–IV address rationale, organization, and oversight in more detail.

*Source: _wp07227 - Introduction: Access to Finance and Public Policy (PDF chapter).*

### Section V concludes.

### _wp07227 - Section V concludes.

### Rationale of Public Financial Institutions
- All surveyed institutions cite market incompleteness, market failures, or externalities as the basis for intervention.
- Housing finance:
  - Market failures: mismatch between demand for long-term fixed-rate mortgages and banks financed by demandable deposits creates liquidity risk and interest rate risk.
  - Hedging depends on market development: short-term bridge borrowing requires deep money and bond markets; interest rate swaps require developed interest rate derivatives markets; long-term bank borrowing requires developed private pensions or life insurance sectors.
  - Mortgage credit risk can be systematic, amplified by correlated house prices and business cycle co-movement.
  - Social housing: preferential financial access may be used for welfare objectives in some countries (e.g., Canada).
- SME and innovation finance:
  - SME market failures: lack of collateral, credit history, and high transaction/agency costs can trap creditworthy SMEs.
  - Innovation finance requires depth and coordination across early-stage financiers, later-stage investors, and exit markets (IPOs/mergers).
  - Positive externalities: SMEs and innovative firms generate employment and technology spillovers.
- Community finance:
  - Deficient access in remote/poor regions due to lack of community-specific statistical information and capital drain.
  - Typical public responses include Spaarkassen/Landesbanken (Germany) or directed schemes like the U.S. Community Reinvestment Act.
- Agriculture:
  - High systemic and catastrophic risks (low crop yields, disease), low profitability, long gestation periods; markets may undersupply credit, especially to small/family farmers.
  - Externalities and need for universal rural coverage justify interventions in some cases.
- Validity of rationales:
  - Some rationales may be outdated or excessive. Housing finance historically justified public involvement but today may be largely served by developed markets except for social housing.
  - Public housing programs in the U.S. account for about 40 percent of GDP in government-sponsored lending and guarantees; in Canada, Germany, and Japan the figure is in the region of 7 percent to 10 percent of GDP.
  - SME finance programs, if improperly targeted (e.g., lending to medium-sized or larger firms), can crowd out private credit and create inefficiencies.

### Organization and Financial Instruments
- Six distinct instruments identified:
  - Direct lending to ultimate borrowers.
  - Intermediated lending to private lenders earmarked for target sectors.
  - Public securitization—purchasing loan portfolios.
  - Guaranteed market securitization—guaranteeing LBS/MBS.
  - Credit guarantees on private loans and securities issuance.
  - Market liquidity provision—public portfolio investments to deepen markets.
- Trade-offs:
  - Intermediated finance outsources screening/monitoring to private lenders and can foster market development; direct lending may be justified for universal coverage or synergies with nonlending services.
  - Intermediated lending can create agency problems; mitigation tools include caps on lending/guarantees, periodic reviews with performance-based bonuses/sanctions, and “smart subsidies” (ex-post grants to repaying borrowers).
  - Guarantees engage private lenders and initially avoid public cash outlays but can encourage lax underwriting and obscure fiscal risks; empirical scarcity of risk assessments for guarantees is noted.
- Recent trends:
  - Public institutions increasingly provide mezzanine and equity-type instruments (e.g., BDBC, KfW Foerderbank, Regional Venture Capital Funds in the U.K.).
  - Venture capital exposure is risky: BDBC reported losses in five out of seven years, with maximum loss of 20 percent of investment in 2002/03.
- Directed lending (outside study) can act as an implicit tax on banks and may compromise intermediary soundness.

### Financing, Subsidization, and Ownership
- Typical financing: borrowing from financial markets; markets perceive implicit guarantees even when not explicit.
- Japan example: Fiscal Investments and Loan Fund (FILP) issues government-guaranteed bonds to fund public lenders at policy-adjusted market rates (mechanism noted as under reform).
- Subsidization:
  - Many public lenders are formally intended to break even but enjoy implicit subsidies via preferential market access, sometimes tax breaks and simplified regulation.
  - Implicit subsidies arise from guarantees; these lower measured profitability but reflect social lending to less creditworthy borrowers.
- Credit guarantee programs:
  - Target smallest firms lacking collateral; commonly loss-making and explicitly subsidized.
  - Observed loss measures vary from 2.6 percent of lending in Canada to 35 percent of loans that default in the U.K.
- Ownership structures in sample:
  - Wholly government-owned, nonprofit corporations (most common).
  - Programs within executive departments (smaller, narrow focus).
  - U.S. examples of privately-owned, publicly-chartered entities: Fannie Mae and Freddie Mac (private for-profit), Federal Home Loan Banks and Farm Credit System (private bank-owned cooperatives).
  - Shoko Chukin Bank (Japan) as joint public-private with government majority (planned privatization).
- Risks of private co-ownership: option value of government guarantees can incentivize private owners to seek rents via socially inefficient expansion.

### Oversight, Prudential Requirements, and Challenges
- Need for strong oversight:
  - Arguments for more stringent oversight prevail because public institutions often face higher and less diversifiable risks, worse managerial incentives, and potential systemic/fiscal consequences upon distress.
  - Public financial institutions resemble “too-big-to-fail” banks; preventive supervision with continuous on-site teams is suggested by analogy.
- Oversight in practice:
  - Multiple administrative oversight layers exist in some systems (e.g., Canada: ministries, central agencies, external auditors, Auditor General special examinations every five years).
  - Corporate governance: governments commonly appoint CEOs and Boards; Boards may include public officials, industry representatives, or independent directors.
  - Routine external financial supervision is generally lacking in sample institutions; none is fully supervised by the principal financial sector supervisor. Japan: annual reports submitted but not subject to routine inspections.
  - Dedicated supervision exists in the U.S. (Office for Federal Housing Oversight; Federal Housing Finance Board); benefits versus mainstream supervision are ambiguous.
  - Shared supervision (financial regulator + ministry in charge) creates enforcement distribution challenges and potential conflicts.
- Capital and prudential requirements:
  - Majority of studied public financial institutions do not have capital requirements; some voluntarily comply (Canada, Germany); Fannie Mae, Freddie Mac, Federal Home Loan Banks have significantly lower capital requirements.
  - Interpretation: government guarantees substitute for capital cushions—reducing market discipline but obviating some capital functions.
  - Risks of substitution:
    - Fiscal risks often unmeasured; contingency planning lacking.
    - Guarantees lack automatic limits on expansion that capital requirements impose, creating incentives for activity growth.
  - Recommendation stance: capitalization is advisable as a default solution over guarantees.
- Governance and transparency challenges:
  - Within-government conflicts of interest between owner and supervisor.
  - Political pressures can compromise supervisor independence.
  - Lack of market discipline reduces price signals for regulators.
  - Many boards lack independent representation; industry representatives can favor expansion. Japan’s managerial boards often lack outside membership.
  - Simplified accounting/disclosure is common but may reduce transparency; need for greater disclosure of financial performance, risk assessments, and policy objective achievement is emphasized.

### Key Findings and Policy Implications
- Focus and narrow mandates:
  - Public financial institutions should be narrowly focused on verified market failures to minimize market distortion, reduce vested interests, and facilitate reform or downsizing.
  - Narrow focus aids transparency, oversight, and limits to activities that crowd out private sector.
- Oversight principles (summary direction):
  - Supervision should be at least as stringent as for private banks due to higher risks and fiscal exposure.
  - Consider preventive supervision practices used for TBTF banks.
  - Prefer capitalization over reliance on implicit guarantees; where guarantees exist, quantify fiscal exposures and establish contingency plans.
  - Increase disclosure of risk assessments and performance vis-à-vis policy aims.
  - Use intermediated finance by default unless clear case for direct lending exists; use guarantees cautiously with strict underwriting controls and monitoring.
  - Apply mitigants to agency problems in intermediated finance: caps, periodic performance reviews, and carefully designed smart subsidies.
- Fiscal accountability:
  - Make government exposures explicit where possible; adopt explicit guarantees as default for accountability.
  - Measure and plan for potential fiscal costs of large, undiversified sectoral exposures (e.g., housing).

*Italic: Source — Section V concludes, _wp07227 - Section V concludes.*

### 1.      An effective legal and regulatory framework

### 1.      An effective legal and regulatory framework

### Major themes from the analysis
- Ten Principles for the Effective Supervision of State-Owned Financial Institutions derive from the Basel Core Principles of Banking Supervision and emphasize: regulator’s independency, ability to oversee capital adequacy, disclosure, and risk-management practices, and enforce corrective measures if necessary.
- The substitutability between regulation / supervision and corporate governance mechanisms in controlling performance of public financial institutions.
- Transparency of public financial institutions is currently lacking and difficult to achieve due to limited market discipline.
- Different financial and institutional jurisdictions can lead to divergence of optimal oversight structures; developing countries may benefit from maintaining robust external regulation and supervision in addition to strengthening governance mechanisms.

### Contributions to future best-principles for oversight
- Principles should reflect substitutability between regulation/supervision and corporate governance mechanisms.
- Principles should put maximum emphasis on transparency of public financial institutions.
- Principles should clearly address issues of differing financial and institutional jurisdictions and the resulting divergence of optimal oversight structures.
- In particular, developing countries may benefit from keeping a more robust external regulation and supervision approach to public financial institutions in addition to strengthening governance mechanisms.

### Key findings from the sample of public financial institutions
- Sample studied: 18 public financial institutions in developed countries.
- Public intervention can correct genuine financial market failures; some examples of well-designed public interventions exist.
- Many studied institutions suffer from inefficiencies apparently stemming from the excessive scope of intervention.
- Some institutions’ activities may be wasteful, distortionary, and pose risks to the stability of the financial system.
- Explicit or implicit government guarantees constitute contingent public expenditures and effectively transfer risks to the taxpayers.
- Some institutions in the sample suffer from weak accountability and oversight arrangements; reforms may be compromised by pervasive entrenchment.

### Policy implications and recommendations
- Reasons for actual or presumed credit market failures should be examined closely before expanding public involvement in financial markets.
- Analysis should focus on addressing market failures with more “market-friendly” and long-term market development policies, such as better regulation, improved property rights, higher transparency.
- In case of doubt, countries may be better off foregoing public development banks altogether, or at least should seek to minimize their scope.
- More investment is warranted and necessary in accumulating evidence and formulating best practices in the organization and oversight of public financial institutions.

### Additional consideration
- Reliance on public banks may have consequences for the conduct of monetary policy: when credit is intermediated under artificial (nonmarket) interest rates, this may hamper the normal transmission mechanism.

*Source: _wp07227 - 1.      An effective legal and regulatory framework*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp07227.pdf_