Decentralization of some governmental functions is taking place in many developing and transition countries. Decentralized entities are becoming responsible for undertaking various infrastructure investments required to meet basic needs at the local level, including utilities, water and sanitation, transportation, health and education, and environmental protection. Owing to fiscal constraints at the center, decentralized entities can rely only partly on capital grants from the center to fund these investments. To meet their funding needs, decentralized entities, therefore, need to broaden their own resource base, access subnational bond markets, and increase the efficiency of resource use. In emerging-market countries, these funding needs must be weighed against the prospect that multiple issuers of securities with varying claims to sovereign creditworthiness will fragment a nascent market and thereby reduce its liquidity and efficiency. On the other hand, properly managed subnational bond market can complement the national bond market.
Subnational entities have traditionally had restricted access to capital markets, partly due to central government’s concerns on fiscal policy. If subnational entities are limited in their bond market access, they will need greater local resources or national assistance if they are to continue to meet their mandates.
11.1 Introduction
Efficient and well-regulated subnational bond markets are essential for financing local infrastructure investments. When they work well, these markets can be a powerful force for raising resources from savers, pricing subnational credit, and providing diversified financing products tailored to the needs of subnational borrowers. Financing can be through financial intermediation (i.e., through banks) or directly placed debt. However, the issuance of subnational securities in emerging-market countries presents significant challenges to policymakers concerned with bond market development.
Each country’s constitutional and political framework and the condition of its financial system determine the feasibility and viability of a market for subnational bonds. The prospects for a market in subnational securities are a function of the degree of decentralization and devolution of government powers, especially regarding taxation. In addition, there are different levels of government (subnational, state or provincial, and municipal agencies), and the suitability of financing alternatives can differ. Furthermore, in many countries, the prerequisites needed for development of a subnational bond market do not exist or suffer from major shortcomings. These deficiencies hamper development of the market for both intermediated and directly placed subnational debt.
The overarching problem of subnational securities issues is that they generate moral hazard, i.e., the expectation by subnational bond issuers and/or market participants that the national government might be prevailed upon to assume the liabilities or the debt-servicing obligations of a distressed subnational borrower. This problem arises as a result of soft budget constraints in the fiscal decentralization system and deficiencies in the public debt framework. The problem of moral hazard is often compounded by lack of market transparency, weakness of market governance, distortions in the competitive framework among market participants, and weak capacity for financial management by subnational entities. An added and fundamental problem in emerging markets is the risk that issuance by subnational entities will fragment the debt market to the disadvantage of all issuers, not least national governments. The extent to which an active market in subsovereign debt is desirable is ultimately a question of whether the benefits of greater decentralization and their financing requirements outweigh the inefficiencies of moral hazard and market fragmentation. Careful management of national and subnational bond market development can mitigate these concerns.
Even in countries where the fundamental prerequisites for subnational debt market development have begun to take hold, significant weaknesses often remain in the framework for developing the subnational bond market. These include weak linkages between development of the national and subnational bond markets, deficiencies in the regulatory and supervisory framework for subnational bond issuance and trading, and weaknesses in the relationships among bond market players and in instruments for credit enhancement and pooling.
This chapter discusses the importance of subnational debt markets in developing and transition countries, introduces some concepts that are useful in understanding subnational debt market development, and examines major policy issues in developing subnational debt markets, including fundamental constraints hampering the development of the market for both intermediated and directly placed subnational bonds. In addition, the chapter discusses the interrelationship of the domestic national and subnational bond markets and the regulatory framework of the subnational bond market. Finally, the chapter reviews the priorities for policy reforms required to strengthening the subnational bond market in developing and transition countries.
11.2 Subnational Bond Markets in Perspective
11.2.1 Importance of Subnational Debt Markets in Developing and Transition Countries
The trend toward decentralization has intensified in many developing and transition countries. In more than 70 countries where the World Bank Group is active, subnational entities—including states, regions, provinces, counties, municipalities, state enterprises, and local utility companies—are becoming responsible for delivering a wide range of local services and investing in local infrastructure. Many of these investments have become necessary as a result of rapid urbanization. However, because of fiscal constraints faced by central governments, many subnational entities can rely only partially on capital grants from the central governments to fund these investments. In addition to improving the efficiency of resources and increasing the participation of the private sector in local services and infrastructure, they need to access bond markets to finance these investments.
The financing needs of subnational entities can be a stimulus for developing both the domestic and subnational debt markets. Subnational debt markets can effectively raise resources from savers, correctly price subnational credit, and efficiently allocate capital among competing subnational investments through diversified financing products tailored to the needs of subnational borrowers. These products can be structured flexibly. They range from instruments secured against the full faith and credit of the subnational entity, to instruments secured through a specific revenue stream, or a combination of both. Subnational debt markets can perform their role through delegated monitoring by financial intermediaries and through direct placement of debt with investors. At the same time, a multiplicity of subnational issues in a country’s bond market that is still relatively undeveloped can fragment the market and make the establishment of national issue benchmarks more difficult. (See Chapter 4, Developing Benchmark Issues.)
While sizeable subnational debt markets have begun to emerge in such countries as Argentina and Brazil, where they account for about 5 percent of GDP, they remain embryonic in the vast majority of developing and transition countries. As such, in 1997 the stock of subnational debt in Argentina amounted to US$17 billion ($500 per capita) and $128 billion in Brazil ($800 per capita). In comparison, that of Germany totaled $69 billion ($800 per capita), Japan $322 billion ($2,500 per capita), and the United States $1,063 billion ($4,000 per capita).231 The contrast is especially striking in the advanced transition countries of Central Europe, where subnational debt markets typically remain below 0.5 percent of GDP, despite considerable progress achieved in financial sector restructuring, privatization, and capital market deepening and diversification, and despite the growing demand for local infrastructure investment in light of possible EU accession. As a result, in many developing and transition countries there is a prospective gap between the rapidly increasing investment financing needs of subnational entities and the capacity of the domestic subnational debt market to meet these financing requirements. The emergence of an orderly and efficient subnational debt market can address this potential development constraint.
11.2.2 Agency Problems and Subnational Debt Markets
In most developing and transition countries, subnational debt markets share a common distinguishing feature—a prevalence of agency problems.232 One manifestation of the agency problem is that of “hidden action” in which subnational borrowers may have an incentive not to repay their lenders.233 They may believe that they will be bailed out by the central government in case they default, thereby creating a problem of moral hazard. (See Section 11.3.1.) A second agency problem likely to appear is that subnational borrowers may have an incentive not to reveal certain characteristics about themselves to their lenders, resulting in “hidden information” and “adverse selection.”234 The incidence of these agency problems will vary considerably depending on the structure of the subnational debt market in different countries.
At one end of the spectrum are countries with subnational debt markets in which the central government combines the functions of allocating capital grants and credit to subnational entities. Such centralized allocations are subject to conversion risk, which arises when these entities use part of the grant for purposes other than those intended. This risk is heightened when the central government has an inadequate monitoring mechanism. Centralized grant and credit allocations also are subject to inefficiencies in the use of funds, which result from the lack of incentives for the subnational entity to use its best efforts when undertaking a project, from imperfect information at the center about the local conditions where funds are allocated, and from the lack of a credible threat of no future financing.
At the other end of the spectrum are countries where decentralization is accompanied with a high degree of self-government and policy and project implementation on the part of the subnational entity. In these countries, the central government concentrates on capital grant allocation to subnational entities for projects for which private financial intermediaries and investors also provide financing, and loans to these entities compete with those from the private sector without an explicit or implicit guarantee for repayment from the central government. This market structure is still subject to the same conversion risk mentioned above, but the likelihood of inefficiencies in the use of funds inherent in the centralized allocation system is reduced because the decentralized credit system makes the threat of no future financing more credible. The decentralized structure also allows the central government to concentrate its resources on strengthening the efficiency of the grant allocation system by applying clear economic allocation criteria for grants and through effective monitoring and incentive systems for implementation of investment projects by subnational entities.
In the middle of the spectrum are countries with intermediate market structures. For such countries, the presence of multiple channels for grant allocation and for lending, both within the central government and among specialized agencies and state-owned financial intermediaries, amplifies the agency problems encountered in a centralized market structure. This results in multiple principal and multiple agent problems, and in implicit or explicit central government guarantees, which increase the risks of moral hazard and adverse selection. Additional agency problems may arise between state-owned financial intermediaries and private financial institutions, particularly in an environment where state-owned financial intermediaries are protected by special regulatory provisions or fiscal privileges that result in a non-level market playing field.
11.3 Developing Subnational Debt Markets: Policy Issues
11.3.1 Moral Hazard
A major concern about the issuance of securities by subnational units is that they often lead to expectations that the central government might assume the liabilities or debt-servicing obligations of a distressed subnational borrower, thereby resulting in a moral hazard problem. Moral hazard in the subnational finance market has two fundamental sources—ex ante and ex post. Ex ante, moral hazard may stem from soft budget constraints in the system of fiscal decentralization, in the public debt framework, and in the financial sector itself. If a subnational entity defaults on a debt obligation, moral hazard arises through expectation of a bailout, or, indirectly, through expectation of intervention by the central government. Ex post, moral hazard may come from the modalities of actual intervention by the central government, in case of subnational entity default or in case of arrears on a nondebt fiscal obligation. In both cases, the way the central government structures its intervention, in terms of conditionality and of actual losses imposed on the parties concerned, determines the extent of a bailout or the degree to which moral hazard is increased as a result of intervention.
Another critical issue is the central government’s political determination to stand aside when a subnational government defaults on its debts, or to impose a real cost on the subnational authorities as the price of government assistance. Ultimately, however, political constraints may limit the central government’s willingness to impose the hardships of bankruptcy on the citizens of a subnational unit who form part of the national electorate.
In addition, to the extent that there is no assurance that the central government will assume the debt obligations of a subnational entity, the creditworthiness status that surrounds such debt obligations has implications for the development of subnational bond markets. If market participants are convinced that the central government will bail out a subnational entity, and in a sense regard subnational bonds to carry an implicit central government guarantee, the attractiveness of subnational bond issues will be enhanced. On the other hand, if market participants have doubts about the central government’s response in case of a subnational entity’s inability to meet its debt obligations, it will make subnational bond issues a less appealing financial asset, thereby impeding the development of subnational bond markets. The ability of market participants to assess the likelihood of the central government’s response to a subnational entity’s debt-servicing difficulties for different subnational bond issues will determine as well the prospects of subnational markets to take hold.
The financial circumstances of subnational entities and the financial and political relationship between the central government and subnational units contribute to moral hazard in several ways. The limitations of fiscal autonomy of subnational bodies, the nature of the intergovernmental transfer system, and the character of the financial sector of subnational entities are the principal factors that lead to moral hazard.
The first channel of moral hazard within the fiscal decentralization system originates from limitations to the fiscal autonomy of subnational entities. On the expenditure side, these limitations pertain to mandated expenditures, such as civil servant salaries, or to regulations that limit the ability of subnational entities to adjust costs. A large share of local expenditures not being under the effective control of subnational entities generates moral hazard because it creates the expectation that the central government will intervene to support these mandated expenditures in case of an economic downturn. On the revenue side, these limitations originate from the small revenue base of subnational entities derived from subnational-collected taxes and fees, or from regulations limiting the ability of subnational entities to modify their tax bases and/or rates. A fiscal decentralization system in which local authorities have the authority to borrow independently, but have limited own revenues, encourages subnational borrowers to contract debt obligations against the anticipation of general transfers from the central government, thereby escaping the need to broaden their own revenue base to meet debt-service payments.
The second source of moral hazard originates from specific components of the intergovernmental transfer system, viz., deficit grants, capital grants, and transfer intercept arrangements.
Deficit grants are allocated by the central government to local governments facing an unexpected deficit “through no fault of their own.” In theory, these grants will not generate moral hazard if their allocation rules are rational, transparent, and strictly respected by the authorities. In practice, allocation rules for deficit grants lack transparency and contribute to a softening of their budget constraint.
Capital grants may also be a source of moral hazard, depending on the type of grant concerned and on its implementation. To the extent that there are deficiencies in the monitoring system for these grants, subnational authorities may have an incentive to use the grant proceeds for purposes other than those intended by the central government. The likelihood of such diversions is intensified in cases where there is no distinction between capital and recurrent expenditures in subnational budgets, as is often the case in developing and transition countries.
Transfer intercepts are arrangements under which subnational borrowings are serviced directly by the central government, or under which a lender can seek payment from the central government for an overdue obligation by a subnational borrower. In both cases, payment by the central government to the lender is deducted from the transfer payment made to the subnational entity. These arrangements are appealing to lenders because they provide security for their loans to subnational entities. They also have shortcomings. In the presence of an intercept, lenders may relax their credit criteria and monitoring of subnational borrowers. If a large subnational entity defaults, the central government will be under strong political pressure not to apply the intercept, because the contraction of local services resulting from the intercept would be politically unbearable. However, if the central government suspends application of the intercept or applies it only partially, the credibility of the intercept system is damaged.
Specific types of fiscal or quasi-fiscal obligations of subnational entities to politically powerful constituencies, as in the case of pensions or social security payments, may also generate moral hazard. To the extent that subnational entities expect that arrears incurred on these politically sensitive obligations will eventually be covered by the central government, budget constraint is softened.
The absence of legislation stating unequivocally that subnational debt is not guaranteed by the central government, with possible exceptions to be approved on a case-by-case basis by the central government or by the legislature, is another source of moral hazard. Subnational entities and their lenders may be led to assume that the central government implicitly guarantees subnational liabilities. A bailout expectation is further reinforced by absence of a clear framework for subnational bankruptcy. Even an explicit disavowal of central government support or the presence of subnational bankruptcy legislation may be insufficient to protect against moral hazard, if political pressure builds for the central government to provide support.
A third channel of moral hazard with the fiscal decentralization system is the financial sector channel. The existing guidelines for calculating bank capital, prepared by the Basel Committee on Banking Supervision (BCBS), imply a sovereign guarantee for subnational debt and, therefore, contribute to moral hazard. Under the existing International Convergence of Capital Measurement and Capital Standards issued in July 1988, national regulators allowed discretion as to the risk weightings to be attached to obligations of subnational entities held by banks under their supervision. According to these guidelines, a risk weighting of 0, 10, 20, or 50 percent can be applied for obligations of subnational entities issued in domestic currency. These percentage weightings reflect the amount of capital that a bank must hold for each such obligation relative to the capital that would be held for a corporate debt obligation. No adjustments are made to accommodate creditworthiness, maturity, or other risk factors. As such, banks have a strong incentive to lend to subnational entities rather than to corporates.235 By requiring a lower capital ratio for subnational debt versus corporate debt of a similar creditworthiness, the BCBS standard implicitly suggests that some other form of credit support (i.e., that of the national government) will be made available, thereby rendering the subnational obligations less risky than their inherent creditworthiness would suggest.
Hidden financing schemes, such as Treasury credit lines or specialized state agency credit lines that provide financing to subnational entities at subsidized rates, also contribute to moral hazard. Credit may be subsidized through recurrent budget subsidies and/or through blending of capital grants and loans, the latter originating mostly from international financial institutions. Because these subsidized lines are managed by a central government ministry or by one of it agencies, they are directly vulnerable to pressure from large and politically powerful subnational entities or from powerful coalitions of municipalities. In many cases, repayment of these credit lines is poor because expectation of a bailout by the central government generates a culture of nonrepayment.
Lenders facing the threat of default by a large subnational entity, or of collective default by a group of municipalities, may exert pressure on the central government to intervene whether or not there is an explicit central government guarantee. In the case of external debt, pressure can include a fear that sovereign foreign debt will be downgraded if the central government fails to take over and service the subnational debt in default.236
Additional moral hazard can be generated ex post in the subnational finance market as a result of the modalities of central government intervention in cases of subnational default. For any given set of ex-ante incentives for market participants, additional moral hazard will be generated if these incentives succeed in pressuring the central government to provide support beyond what is stipulated in the legal and regulatory framework. The assumption of a subnational quasi-fiscal obligation by the central government can generate additional moral hazard on the subnational finance market if it is done without imposing a cost on the subnational entity. The transfer of provincial pension systems from the federal government to several provinces in Argentina in 1994 is a good illustration of the importance of specific types of government interventions in dealing with moral hazard. Argentina is the most decentralized country in Latin America, with 50 percent of public spending at the subnational level. However, the bulk of taxation is collected nationally, creating an imbalance that is met by giving provincial governments a “coparticipation” in certain tax revenues that cover, on average, 65 percent of provincial spending. Until 1994, all provinces administered pension schemes covering employees of the province and provincial entities. However, the economic downturn following the Tequila Crisis of 1994–95 rendered many provinces unable to pay pensions and, due to the tax-sharing system, unable to generate additional revenues. As a consequence, it became necessary for the national government to assume the pension obligations.237
11.3.2 Fundamental Constraints in Developing Subnational Bond Markets
Weakness of the local government budgeting, accounting, and auditing framework undermines the quality and reliability of information available to the subnational finance market, thereby inhibiting the development of subnational bond markets. There may, for example, be a lack of distinction between current and capital expenditures in local government budgets. Without this distinction, it is impossible to ascertain whether long-term borrowings by subnational entities are for investment purposes only and whether the effectiveness of prudential rules for local government borrowing is undermined. In addition, multiyear budgeting is often absent at the subnational level.
An additional major shortcoming of subnational entities is an inadequate accounting and risk management framework for asset-liability management. Such a framework is necessary to enable informed judgments about the appropriate currency, interest rate, maturity, and structure of local government borrowings. (See Box 3.1. in Chapter 3.) Furthermore, local governments typically have limited knowledge of their assets, in terms of both ownership and valuation, which limits the feasibility of issuing securitized debt instruments.
Auditing budgets of subnational entities is often the weakest element in the budgetary framework. Local government budget audits are usually a responsibility of the central government’s audit office, but the quality and frequency of these audits are generally low. To overcome these problems, some governments are moving to private sector audits of local government budgets, but broad coverage is often constrained by the limited development of the domestic auditing industry.
Another area of inefficiency may be hidden Treasury or special agency lines of credit, which often have a dominant role in the subnational finance market. This dominant position may be backed up by specific regulations, such as rules restricting subnational entities to borrowing from the Treasury/agency line, or rules prohibiting them from borrowing from commercial banks. Such provisions undermine the emergence of a private subnational debt market. Treasury and/or agency lines may allocate credits to subnational investments at subsidized rates that do not reflect the underlying subnational credit risk. This distorts resource allocation among competing subnational investments and displaces private sector finance for subnational investments.
Transparency and reliable information are also essential for establishing a broad investor base for subnational bonds and for making pricing decisions for subnational issues. The information should include the financial condition of the subnational issuing entity, the intended use of the proceeds of the bond issue, the revenue sources for servicing the bonds, and the nature of any guarantees by the central government.
11.4 Linkages Between Government Securities Markets and Subnational Bond Market Development
11.4.1 Relationship Between the Domestic Government Bond Market and the Subnational Bond Market Development
The government securities market is the foundation for other components of the domestic debt market. In the private sector bond market, most market participants construct yield curves from observations of prices and yields in the government bond market. (See Chapter 4, developing Benchmark Issues, and Chapter 12, Linkages Between Government and Private Sector Bond Markets.) Government bonds have traditionally been considered default free, and the government bond market generally offers the most liquid and active trading environment.238 Since subnational bonds carry a greater element of credit risk, and thus a commensurate higher yield, an appropriate comparison is probably with the private sector bond market.
The national government bond market’s benchmark role can become less important as the subnational bond market gains in depth and diversity, or if tax or regulatory considerations play an important role in determining yield. Over time, prime-rated subnational issues may even become the dominant points of reference for establishing a yield curve for particular subnational issuers. Thus a subnational bond market may develop relatively independently of the evolution of the national bond market. For such an orderly outcome, development of both bond markets must be well managed.
Subnational bonds are likely to be smaller in size and less frequent than those issued by the national government and, therefore, less liquid. Subnational bond issues, thus, are likely to be more attractive for long-term investment purposes than short-term liquidity.
It is generally preferable that the payment and settlement of subnational issues become part of a broad system that covers private sector securities rather than be linked with an exclusive facility for government securities. While a dematerialized delivery versus payment system is invariably to be preferred for all securities settlement (preferably offering real time gross settlement),239 the more practical solution is that the settlement system should be commensurate with the breadth and requirements of the investor base, taking into account the characteristics of the financial instruments. Thus, a market with many institutional investors, with diverse investment objectives, and large issues with a high-credit standing warrants a sophisticated payment and settlement system. However, such an advanced arrangement might not be worthwhile or appropriate for small issues of lower-credit standing, for a more limited number of investors, or if the investors are homogenous.
11.4.2 Role of the Subnational Bond Market in Diversification of the Domestic Fixed-Income Market
Beyond the basic general obligation bonds issued against the full faith and credit of the issuer, the subnational bond market may provide a wide range of dedicated revenue bonds issued for project or enterprise financing and secured by revenues generated from operations of the subnational entity.240 In most developing and transition countries, general obligation bonds still largely dominate subnational bond markets, and revenue bond and structured bond financing is emerging slowly.241 As markets develop, however, local governments tend to diversify their borrowing instruments and rely more on revenue bonds. This diversification has been observed in several Latin American countries, as subnational entities reentered the national bond market in the wake of stabilization programs following the 1994–95 Mexico crisis. The change from general obligation to revenue bonds in these countries also met the demand from institutional investors for additional security in purchasing subnational bonds.242
11.5 Issuance of Subnational Bonds
In contrast to government bond issues, which are often issued through an auction arrangement (see Chapter 5, Developing a Primary Market for Government Securities), auctions are used to sell subnational bonds only in a few countries. In India, for example, subnational bonds are sold alongside national government securities by the central bank, and are purchased in the first instance by primary dealers, commercial banks, and other participants in government securities auctions. The subnational bonds are then settled like other government bonds through the central bank clearing and settlement systems.
More typically, however, bonds issued by subnational entities follow the practices of the corporate (or Eurobond) fixed-income markets. Such issues take the form of public issues or private placements. In the former, bonds are sold to a wide range of investors, usually by a syndicate of several underwriters. In a private placement, the bonds are sold to a very limited number of investors by only one investment bank.
While individual circumstances vary, in a public issue it is more common for the issuer to be underwritten so that the issuer is guaranteed that a given amount of bonds will be sold at a given interest rate or at a given margin over a reference rate. This process can follow a competitive bid process, where a number of banks or syndicates of banks acting together are requested to give their best price (or yield) for a given amount of bonds, with the mandate to carry out the financing being awarded to the bank that guarantees the best terms. The situation whereby the final terms of an offering are determined before coming to market is also known as a “bought deal.” Alternatively, a public offer may be in the form of a negotiated sale where the issuer chooses the underwriter(s) first and subsequently agrees to the terms of the bond. In a negotiated sale, the underwriter(s) may also purchase the bonds as a bought deal or may follow a book-building exercise whereby the investment bank(s) launch the issue and publicly take soundings from potential investors as to pricing. In a private placement the transaction may also take the form of a bought deal or may be on a best efforts basis whereby the investment bank is only required to purchase bonds to the extent that investors have been identified.
For both public and private issues, the subnational borrowing entity (for example, a municipality) may or may not make use of the services of a financial advisor. The financial advisor is typically an investment bank familiar with the securities markets, which, instead of buying bonds from the issuer, acts as an advisor to ensure that the terms and conditions offered by the underwriting banks are the best that could be obtained in the circumstances. The financial advisor will guide the issuer as to market conditions, the level of interest rate the borrower should expect to pay (the coupon), and the optimal bond maturity to meet investor demand. For more complex bond issues, the financial advisor may enter into details of the bond structure. The financial advisor may help the issuer select underwriters and also assist the issuer in the preparation of the bond documentation. However, the primary responsibility for documentation is assumed by the “Bond Counsel” lawyers retained by the issuer to prepare the documentation that generally consists of an underwriting and selling agreement, which determines the agreement between the issuer and the underwriter, an offering circular (or prospectus), which represents the basic terms of the transaction to potential investors, financial information on the issuer, and the trust indenture (or fiscal agency agreement), which contains the obligations of the issuer and the legal rights of investors and determines the processes through which investors can exercise their rights and the issuer communicates with investors, invariably through a trustee or fiscal agent.
Practices vary between countries, but typically a bond issue by a subnational issuer will close one to two weeks after the launch date. The launch date is the date the offering circular is provided to the investors, and the closing date is the date the issuer receives the funds.243 The payment to the issuer is made by the underwriting syndicate against delivery of the physical securities, typically represented by a temporary global note, which is later exchanged for definitive securities. The securities are delivered to a depository system (such as the Depository Trust Company in the United States), and all payments are channeled through this system. The bonds may or may not be listed on a stock exchange. However, the listing does not mean that the bonds will necessarily trade on that exchange. The listing merely represents that certain standards of disclosure have been met.
11.6 Development of the Secondary Subnational Bond Market
As an initial step in secondary subnational bond market development, subnational entities may issue bonds to banks, and the banks may decide to keep these bonds on their books and treat them as a de facto loan. Subsequently, banks and other underwriters may opt for private placements of such bonds with selected domestic investors, such as pension funds, insurance companies, or mutual funds. A market in subnational bonds then emerges, as rated subnational entities opt for a public placement and institutional investors may decide to trade the subnational bonds held in their portfolios.
A range of direct and indirect measures can support development of secondary markets for subnational bonds. In terms of direct measures, some countries are exploring ways to facilitate the listing of subnational bonds on domestic stock exchanges and to encourage the development of pre-indication posting of indicative price information (including coupons, yields, offer amounts) or other municipal finance information systems.244
To promote secondary market trading of subnational bonds, several indirect measures can be taken. Removing minimum requirements for institutional investors to hold government securities, including subnational bonds, eliminates the bias toward private placement inherent in the system and increases the incentives for institutional investors to trade such bonds. (See Chapter 6, Developing the Investor Base for Government Securities.) These techniques, however, increase issuance costs and may also increase debt-servicing costs.245 Such measures also increase the risks of the portfolio. (See Chapter 3, A Government Debt Issuance Strategy and Debt Management Framework.)
11.7 Regulatory and Supervisory, Legal, and Tax Framework for Subnational Bond Market
11.7.1 Regulatory and Supervisory Framework for Subnational Bond Market
The basic regulation for subnational bond markets is the securities law. Since subnational entities compete directly with corporations for scarce resources, the regulations pertaining to issuance, initial and continuing disclosure, and settlement that are applicable to private sector securities should apply to subnational issues. (See Chapter 12, Linkages Between Government and Private Sector Bond Markets.)
Ultimate supervisory authority for the subnational bond market should rest with the securities market regulator. The market regulator may be modeled as a self-standing body, such as the Securities and Exchange Commission (SEC) in the United States, or as a specific department within a banking and capital markets supervisory agency, such as the Financial Services Authority (FSA) in the United Kingdom. Given the high fixed costs of establishing an effective regulatory and supervisory capacity, centralized market supervision246 would seem appropriate for developing and transition countries that have nascent subnational bond markets. As the regulatory and supervisory framework for the subnational bond market gains strength and as the market reaches a certain volume of transactions, the authorities may consider supplementing centralized supervision with self-regulation among market participants. One option is to establish a self-regulatory body, such as the Municipal Securities Rulemaking Board (MSRB), that regulates the municipal bond market in the United States. This self-regulatory organization is subject to oversight by the SEC and is comprised of representatives from the municipal bond industry, the public, and government agencies. It provides guidelines for the preparation, sale, disclosure, and secondary trading of municipal bonds. The MSRB has authority to make rules regulating the municipal securities activities of banks and securities firms only. It does not have authority over issuers of municipal securities.247 Another option is to delegate self-regulatory activities to other players in the market, such as commercial banks or trust organizations.
11.7.2 Legal Framework for the Subnational Bond Market
All provisions of the commercial code establishing the rights and obligations of creditors and borrowers in the financial market should apply to the subnational bond market. Similarly, the judicial framework for the enforcement of creditors’ and borrowers’ rights and obligations, and for the settlement of commercial disputes, should also pertain fully to subnational bond market participants. Some investors and financial intermediaries may be reluctant to enter the subnational bond market because they fear that their rights will not be protected and that they will not be able to rely on the judicial system in case of commercial dispute with a subnational entity. Enforcing foreclosure on local government assets pledged as collateral and enforcing covenants on local government revenue collateral are particular areas of concern.
Market governance also suffers from lack of a subnational bankruptcy framework, which can help clarify the rights and obligations of creditors and borrowers in case of default. Several countries have attempted to rectify this shortcoming by introducing a Chapter 9–type procedure248 to regulate debt clearance in case of default by a subnational entity.249 However, local government bankruptcy legislation is not a panacea. Its effectiveness depends on the degree of independence of the judicial body responsible for triggering the debt clearance procedure and overseeing its implementation, and the independence of the court-appointed public officer responsible for conducting the procedure. Legislation of this type does not address the fundamental agency problems of moral hazard noted in Section 11.3.1 above, and in all countries the application has been limited to minor entities unable to exercise leverage at a higher level of government.250
11.7.3 Tax Treatment of Subnational Bonds
In the United States, interest earned from municipal bonds is exempt from federal interest income tax, but such exemption is subject to criticism. Tax exemption narrows the market for subnational bonds and could increase bond yield volatility. It makes bond yields more sensitive to changes in the distribution of investable funds between individuals and financial institutions. It also introduces variability in the value of the capital-cost subsidy enjoyed by municipalities. Tax exemption is economically inefficient, in that it encourages overproduction of public services and overuse of capital by the public sector. In addition, tax exemption is inequitable, because it erodes the vertical equity in the tax system by allowing the high-income group to benefit from a special tax feature that is not of value to the lower-income group. Tax exemption is also financially inefficient, because it imposes greater costs on federal taxpayers than the benefits it confers to state and local governments. Empirical evidence from the U.S. market tends to support this latter claim. For example, in fiscal year 1990, savings from tax exemption for state and local governments were estimated at $17 billion, while the revenue cost to the Treasury was estimated at $22 billion.251 (For a broader discussion of taxation issues related to bond markets, see Chapter 10, Development of Government Securities Market and Tax Policy.)
11.8 Credit Enhancement and Credit Pooling in Subnational Bond Markets
11.8.1 Credit Enhancement for Subnational Bond Market
In addition to playing a central role in the issuance of subnational bonds, financial advisors can play a major role in helping subnational entities access the market. (See Section 11.5 above.) The Bond Counsel of the subnational entity also plays a central role in ascertaining an issuer’s authority to issue bonds, raise taxes or fees, and attach collateral.
A credit-rating agency can also be important in establishing the credit standing of a subnational borrower. On domestic markets, rating regulations vary across countries.252 The credit-rating process may also influence subnational entities’ policies directly, as officials may avoid certain policies that might lower the entity’s credit rating in the future. Some countries have laws that require a subnational entity that issues a bond on the international market to obtain an international credit rating.
In addition to tax exempting interest earnings from municipal bond holdings (see Section 11.7.3 above), governments have adopted several other measures to make subnational bonds attractive to investors. Refunded bonds are one such technique. Refunded bonds are bonds originally issued as general obligation or revenue bonds, but subsequently collateralized, either by direct obligations guaranteed by the central government or by other types of securities. Maturity schedules of securities in an escrow fund are structured to pay bond principal, interest, and any premiums on a refunded bond.
Bond insurance is another credit enhancement method that can play a major role in deepening the market for subnational debt issues in developing and transition countries.253 This process is superficially attractive in that sophisticated financial institutions can assume the responsibility of reviewing the complex and opaque financial condition of a subnational borrower and convert a weak investment-grade credit into a higher-grade offering. Bond insurance can be particularly important for large bond issuers or less than high-quality bond issuers that need to raise money in weak market environments. It can be also be attractive for lower-quality bonds, bonds issued by smaller subnational units not widely known in the financial community, bonds that have a sound but complex security structure, and bonds issued by subnational entities that borrow infrequently and do not have a general following among investors. The improvement in marketability gained by bond insurance can provide a net interest cost saving to the issuer or access to the market.
However, the issuance of bonds through the use of credit enhancement is relatively inefficient in comparison with direct intermediation by a financial institution, such as a bank, insurance company, or pension fund, acting as an investor. Credit-enhanced bond issues can only be competitive in cases, as in the United States, when there is a tax (or regulatory) constraint that impedes direct lending by sophisticated financial institutions. Moreover, in practice, the use of bond insurance has not always overcome the problems of moral hazard.254
Over the past two decades, bond insurance has been supplemented by other forms of credit enhancements provided by banks, such as irrevocable lines of credit.255 Other types of less formal credit support can also be arranged, such as a put option requiring the counterpart to purchase a bond under predetermined circumstances. These kinds of third-party guarantees can be purchased from banks in a large number of transition countries. In addition, a growing number of international companies that provide credit guarantees have been created by private investors and international financial institutions and are open to providing guarantees for bond issuance by subnational entities.
11.8.2 Bond Pooling by Subnational Entities
Despite the development of bond insurance and other forms of credit enhancement, market access remains limited for subnational entities with poor credit ratings or limited credit experience and for small issuers. Since the early 1970s, state bond bank initiatives have emerged in the United States as a possible way to address this problem. A bond bank is a conduit financial institution that issues a bond on the market equal to the sum of the individual issues plus a reserve fund, and uses the proceeds to purchase the bonds issued by participating subnational units. It is similar to a municipal development fund (MDF), but typically relies on market-based financing through debt issues. The primary security for the bank issue is the subnational entity’s pledge to repay principal and interest on its share of the debt issued, which can take the form of a full faith general obligation or a dedicated revenue pledge. State bond banks review the applications of individual subnational entities until sufficient credit demands have been made to warrant a bond issue. Although most bond banks are self-supporting operations that do not receive direct state appropriations or the state’s full faith and credit backing, many are secured by a moral obligation. Giving the bond bank the right to intercept state transfers to the subnational unit in case of default may provide additional security. Credit-rating agencies consider the state to be the ultimate source of debt repayment for bond bank issues. In the absence of state support, rating agencies have tended to rate the debt issues of bond pools according to the lowest credit supporting the cash flows, thereby eliminating any benefits of pooling.
Bond banks suffer from several limitations. Since the bank acts as a conduit for subnational issuers to access national credit markets, a permanent funding pool is not created. A moral obligation pledge by the state and/or the establishment of an intercept right may create the expectation of a bailout by the state and could be a moral hazard for the subnational finance system.
11.9 Priorities for Policy Reform for Subnational Bond Market Development
11.9.1 Establishing a Foundation for Subnational Bond Market Development: A Policy Matrix
This section presents a framework for policy reform aimed at establishing prerequisites for subnational bond market development. The framework is presented in the form of a policy matrix. (See Table 11.1.) The vertical axis is organized around the major policy objectives inherent in the development of subnational bond markets in developing and transition countries, while the horizontal axis is organized around types of financial systems, from closed systems (state-dominated financial sectors) to open systems (competitive, diversified market-based financial sectors), with intermediate systems between the two extremes. The policy matrix presents for each policy objective and market structure the principal policy reforms required to establish the foundation for the development of a sound subnational bond market.
Major Policy Reforms to Develop a Subnational Bond Market
(by policy objective and type of financial system)
Major Policy Reforms to Develop a Subnational Bond Market
(by policy objective and type of financial system)
| Policy Area | Closed System (state-dominated financial sector) | Intermediate System (market-based financial sectors) | Open System | |
|---|---|---|---|---|
| Reducing moral hazard | Establish tight limits on government lending to subnational entities | Establish fixed shared revenue formula | Diversify own-source revenue base | |
| Establish subnational authority over own-source revenue rate setting (taxes and user fees) | ||||
| Unify capital grant allocation system | Establish explicit rules for capital grants allocation | Limit capital grants to cover cost of externalities that cannot be internalized | ||
| Introduce monitoring system to guard against diversion of capital grants | ||||
| Control quasi-fiscal liabilities of subnational entities | Limit government guarantees for subnational transactions | Integrate guarantees and other contingent liabilities in debt of subnational entities | ||
| Establish provisioning rules for subnational guarantees and contingent liabilities | ||||
| Remove preferential capital adequacy treatment for subnational debt held by banks | ||||
| Control large subnational exposure by domestic financial intermediaries | Progressively relax prudential rules in line with opening of market competition | |||
| Establish prudential framework for borrowing by subnational entities | ||||
| Improving market transparency | Introduce separate current and capital accounts in subnational budget | Introduce subnational accrual accounting system | ||
| Establish central/subnational asset designation | Introduce subnational asset valuation | |||
| Introduce subnational accrual accounting system | Define treatment of subnational guarantees and other contingent liabilities in concession legislation | |||
| Strengthen subnational auditing | Develop domestic private auditing industry | |||
| Define specific formats for debt disclosure by subnational entities | Review formats for debt disclosure in line with evolution of subnational accounting framework | |||
| Strengthening market governance | Ensure equal treatment for subnational entities in commercial code | Introduce subnational bankruptcy law | ||
| Establishing level playing field in market | Separate capital grants system and central government-run financing schemes | Phase out central government financing schemes | ||
| Phase out MDF protective fiscal/regulatory framework | Increase private sector participation in MDFs | |||
| Phase out rediscount window | ||||
| Developing subnational capacity for budget, accounting, and financial management | Establish basic cash accounting framework | Develop accrual accounting framework | ||
| Establish basic current/capital budgeting framework | Develop basic capacity for liability management | Develop advanced asset-liability management framework |
Major Policy Reforms to Develop a Subnational Bond Market
(by policy objective and type of financial system)
| Policy Area | Closed System (state-dominated financial sector) | Intermediate System (market-based financial sectors) | Open System | |
|---|---|---|---|---|
| Reducing moral hazard | Establish tight limits on government lending to subnational entities | Establish fixed shared revenue formula | Diversify own-source revenue base | |
| Establish subnational authority over own-source revenue rate setting (taxes and user fees) | ||||
| Unify capital grant allocation system | Establish explicit rules for capital grants allocation | Limit capital grants to cover cost of externalities that cannot be internalized | ||
| Introduce monitoring system to guard against diversion of capital grants | ||||
| Control quasi-fiscal liabilities of subnational entities | Limit government guarantees for subnational transactions | Integrate guarantees and other contingent liabilities in debt of subnational entities | ||
| Establish provisioning rules for subnational guarantees and contingent liabilities | ||||
| Remove preferential capital adequacy treatment for subnational debt held by banks | ||||
| Control large subnational exposure by domestic financial intermediaries | Progressively relax prudential rules in line with opening of market competition | |||
| Establish prudential framework for borrowing by subnational entities | ||||
| Improving market transparency | Introduce separate current and capital accounts in subnational budget | Introduce subnational accrual accounting system | ||
| Establish central/subnational asset designation | Introduce subnational asset valuation | |||
| Introduce subnational accrual accounting system | Define treatment of subnational guarantees and other contingent liabilities in concession legislation | |||
| Strengthen subnational auditing | Develop domestic private auditing industry | |||
| Define specific formats for debt disclosure by subnational entities | Review formats for debt disclosure in line with evolution of subnational accounting framework | |||
| Strengthening market governance | Ensure equal treatment for subnational entities in commercial code | Introduce subnational bankruptcy law | ||
| Establishing level playing field in market | Separate capital grants system and central government-run financing schemes | Phase out central government financing schemes | ||
| Phase out MDF protective fiscal/regulatory framework | Increase private sector participation in MDFs | |||
| Phase out rediscount window | ||||
| Developing subnational capacity for budget, accounting, and financial management | Establish basic cash accounting framework | Develop accrual accounting framework | ||
| Establish basic current/capital budgeting framework | Develop basic capacity for liability management | Develop advanced asset-liability management framework |
11.9.1.1 Reducing Moral Hazard in the Subnational Bond Market
Reducing moral hazard requires hard budget constraints across fiscal decentralization, public debt and intergovernmental transfer, and financial sector channels. Within the fiscal decentralization channel and the associated limitations to the fiscal autonomy of subnational entities, the first priority in a closed system is to unify the capital grant allocation scheme in order to reduce agency problems associated with a multiple grant system. As the market structure opens and evolves into an intermediate system, the key priorities are to establish clear rules for capital grant allocation within the unified system and to introduce a monitoring system to limit diversion of conditional grants into general-purpose expenditures. In parallel with these steps, current transfer systems need to be stabilized by introducing a fixed shared revenue formula and establishing subnational authority over own-source revenue rate setting. As the market structure evolves toward an open system, the government can focus on developing diversified, market-based revenue sources for the subnational entity.
Within the public debt channel, the first priority within a closed system is to establish control over quasi-fiscal liabilities of subnational entities and to introduce limits on central government and/or state agency lending to these entities. As the market structure evolves into an intermediate system, the key priorities are to establish an explicit limitation on sovereign guarantees for subnational transactions, clear provisioning rules for subnational guarantees and other contingent liabilities, and a prudential framework for borrowing by subnational entities. As the system opens further, the government can focus on developing market-based pricing of guarantees and other contingent liabilities, and it can relax prudential rules in line with general hardening of the budget constraint.
Within the financial sector channel, the first priorities within an intermediate system are to remove preferential treatment for subnational debt in calculating capital adequacy, to control large subnational exposures by financial intermediaries, and, where they exist, to phase out rediscount windows for subnational loans by domestic financial intermediaries.256 Several measures essential to a level playing field are also critical to reducing moral hazard in the market. These include gradually phasing out hidden financing schemes, such as Treasury and/or specialized agency lines of credit, and the protective framework surrounding municipal development funds (see below).
11.9.1.2 Improving Market Transparency
To promote transparency in the subnational bond market, the first priorities are to establish a subnational accounting framework separating current and capital expenditures, a legislative framework clearly designating subnational assets, regular audit of subnational accounts by the state audit office, and procedures and formats for debt and debt-issuance disclosure and registration by local governments. As an open market structure takes hold, the key policy priorities are to strengthen the subnational accounting system through (i) introduction of accrual accounting, in addition to the traditional cash accounting system; (ii) introduction of market-based valuation for subnational assets; (iii) regulation of subnational guarantees and other contingent liabilities in concession contracts, and the pricing and accounting of these guarantees in subnational budgets; (iv) establishment of the legal and regulatory foundations for a domestic private auditing industry; and (v) revision of formats for debt disclosure and registration, in line with evolution of the subnational government accounting framework.
11.9.1.3 Strengthening Market Governance
Within intermediate market structures, the main priority is to ensure that the legal framework provides the same protection to creditors in the case of claims against subnational entities as in the case of private corporations under the commercial code. As a competitive market develops, the government should focus on introducing an effective subnational bankruptcy framework, focusing in particular on establishing sufficient distance between competent courts and subnational governments.
11.9.1.4 Establishing a Level Playing Field
Establishing a level playing field for the subnational debt market requires taking measures early on in the process of market development and following them through as the market evolves to an open structure. Within closed structures, the key priority is separating the management of unified capital grant allocation and of central government run financing schemes.
11.9.1.5 Developing Local Capacity for Accounting, Budgeting, and Financial Management
Governments should put in place a framework to support development of subnational capacity in accounting, budgeting, and financial management. Initial capacity building efforts should develop liability management at the subnational level. As an open market emerges, further capacity building efforts may focus on advanced asset-liability management techniques and the use of derivative instruments for risk management.
11.9.2 Strengthening Subnational Bond Market Architecture in Developing and Transition Countries
11.9.2.1 Encouraging Synergy Among Various Bond Markets and Within the Subnational Debt Market
While developing the government bond market is rightly seen as essential to establishing a benchmark for the subnational bond market, this relationship tends to become less important as both subnational and private sector debt markets develop. Within the subnational bond market itself, debt issuance by highly rated borrowers increasingly drives development of the market and plays a critical role in setting the reference yield curve for this market. Competition between private sector and subnational debt issuers for scarce investor resources drives the structure of the yield curve for various market segments and powers market deepening and diversification. Beyond developing the government bond benchmark for the market, the key priority is to establish and maintain a neutral policy stance about market access by subnational borrowers and about competition among various non-central government issuers. The cornerstone of this policy is to replace implicit, unlimited government guarantees by explicit but limited guarantees that are adequately priced and accounted for in the national budget.
11.9.2.2 Developing Regulatory and Supervisory Framework for the Subnational Bond Market
Because subnational entities compete directly with private sector issuers for scarce investor resources, the overall regulatory framework for subnational bond issues should parallel that for private sector issues. As an integral part of bond market reform programs, governments should pay particular attention to specific elements of the regulatory and supervisory framework that may require special treatment to account for specific characteristics of subnational issuers. It is especially important to establish specific formats for disclosure of financial information by subnational entities in the case of public issues and to revise regularly these formats as subnational accounting evolves. A priority is to establish specific regulations that support market diversification, increase investor confidence, and foster development of a secondary market in subnational bonds. The regulations should require a legal opinion before subnational bonds are issued; support development of structured subnational bond issues, particularly revenue and asset collateralization; sustain the issuance of bonds by intermunicipal undertakings;257 give institutional investors freedom to invest across a broad range of instruments, including subnational bonds; and construct a tax regime that does not distort investor choice among various classes of securities.
11.9.2.3 Maintaining a Level Playing Field Among Market Instruments and Participants
Once national bond benchmarks are established, governments should establish a legal and regulatory framework that supports development of a wide range of subnational debt instruments, both bank lending and directly placed bond issues. Bank lending plays a central role for subnational borrowers in the middle of the rating scale. As their credit reputation grows and the need for delegated monitoring lessens, subnational borrowers can diversify their financing strategies and seek to place bonds directly on the market. The subnational bond market is closely intertwined with bank lending to subnational entities. Governments should avoid introducing distortions in the system of incentives between subnational bonds and loans, particularly through introduction of fiscal and/or regulatory privileges that favor one type of instrument over another.
Governments should also avoid introducing fiscal, regulatory, or other forms of support that distort competition among various actors on the subnational bond market. They should be careful when providing government support to specific market participants in order not to distort development of normal competitive relationships. For example, providing financial advisory services for bond issuance to subnational entities on a grant basis carries the risk of distorting the choice between competitive and negotiated sales and, therefore, the competitive relationship between financial advisors and underwriters. Providing backup facilities for bond insurers carries the risk of distorting the choice between bank lending and bond issuance and, therefore, the competitive relationship between banks and bond underwriters. Providing sovereign or intermediate government backup for a bond bank reserve fund risks distorting the choice between bank lending and bond issuance for issuers with a limited credit record and the choice between individual issues by small local governments and a combined issue by an intermunicipal undertaking.
11.10 Conclusion
The increasing role of subnational entities in capital markets reflects the trend of decentralization of some governmental functions, particularly for infrastructure investment, from the central government to smaller political jurisdictions. In general, the greater the financial autonomy of subnational units of government, the greater the likelihood that a subnational securities market could develop.
The central government usually issues bonds and bills in the domestic capital market, whether rates are low or high, with the aim of minimizing cost over the long run. In contrast, many subnational issuers (provinces, states, municipalities, and state enterprises) are opportunistic issuers that often do not have a recurrent financing need. They can, accordingly, look for special opportunities in the market by issuing bonds when interest rates are low or by targeting specific segments with high investor demand. For these issuers, timing and flexibility in the design of bonds are essential.
Even with financial autonomy of a subnational unit, a number of concerns arise in developing subnational securities markets. The overarching problem of subnational securities issuers is that they often lead to expectations that the central government might assume the liabilities of a distressed subnational borrower, thereby resulting in a moral hazard problem. In addition, the development of a subnational securities market may fragment the overall government securities market. The extent to which a subnational securities market is desirable is ultimately a question of whether the benefits of the greater financial autonomy resulting from decentralization are outweighed by the inefficiencies resulting from moral hazard and market fragmentation.
A well-functioning government securities market supports the development of securities markets for subnational entities. Providing a relatively risk-free asset such as a government bond establishes a reference for pricing subnational bonds. The market infrastructure needed for an effective government securities market, and particularly payment and settlement arrangements, should be able to serve the needs of the subnational securities market as well.
The lack of market transparency, weakness of market governance, and weak capacity for financial management of subnational entities, however, impede the development of subnational securities markets. To gain market acceptance, subnational units of government must strive to overcome these shortcomings. Moreover, to establish their market standing, subnational bond issuers must be prepared to provide the public with relevant credit information, including the revenue basis for servicing their obligations, and they must establish a reputation for financial integrity. Technology and the Internet may eventually play a role in the information infrastructure by facilitating the dissemination of pricing information from all potential providers of a financial service and relevant financial information about particular new issues and about the issuers.
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Subnational debt as a percentage of GDP varies markedly among OECD countries largely as a function of constitutional differences, so that in the United States subnational debt is around 14 percent of GDP, while in the United Kingdom, it is essentially nonexistent.
When a party, the “agent” is able to take actions on behalf of another, the “principal,” agency problems arise where the interests of agent and principal are not aligned and the agent takes actions that the principal would not have chosen. These scenarios relate to subnational financial markets in that the subnational entity often is able to take actions that will have consequences for the national government.
“Hidden action” describes a situation whereby a party believes it will derive greater benefit from a given action if this action remains unknown. For example, if two countries agree not to pollute a shared lake, the willingness to continue to cooperate is a function of the performance of the other party. However, to the extent to which pollution has taken place does not become apparent until later, the reneging country that pollutes therefore benefits from this hidden action. In the case of subnational debt, hidden action describes the incentive a local authority has to incur greater indebtedness than recognized by the national government. As the national government typically picks up the debt of defaulting local governments, this is said to lead to moral hazard, a situation in which participants do not have to pay for the consequences of their actions.
The problem of hidden information occurs where a party believes it will receive better treatment if certain information is not disclosed. A classic example would be a person with a terminal illness who applies for life insurance and withholds information about his condition. If the life insurance company cannot distinguish who has ill health, the result is that the less healthy people, who know their own state, are more willing to buy life insurance. As a consequence, the insured population results in being less healthy than the population in general (“hidden selection”), which eventually will show up in the cost (premiums) of life insurance.
According to the more recent BCBS proposal, The New Basel Capital Accord, January 2001, this discrepancy would be removed but not entirely eliminated. Under the new proposals subnational obligations rated less than A- would require a capital allocation of one-half to two-thirds that allocated to similarly rated corporate credits. In general, however, there is a closer association of creditworthiness and capital requirements.
This risk became vividly clear in Brazil in early January 1998, when, Itamar Franco, the newly elected Governor of the state of Minas Gerais and President Cardoso’s predecessor, declared a moratorium on his state’s US$5 billion debt to the federal government. Two other important states, Rio Grande do Sul and Rio de Janeiro, also declared moratoria. The action of the states served to undermine Brazil’s position in international financial markets, and there was a marked flight of capital. Minas Gerias had a US$80 million Eurobond repayment due February 10, 1998, and the moratorium put this payment in doubt. The federal government paid the international obligation of Minas Gerais to maintain Brazil’s market credibility.
See Nicolini et al. 1999.
The assumption that government bonds in developing and transition countries are default free has been called into question since the Russian government bond default in August 1998 and the emerging practice of integrating government bonds into debt-restructuring agreements, as occurred with Ecuador in 1999.
In a dematerialized settlement system, investors deposit their securities with one or more common depositories, and the depository becomes the owner of record. Subsequent security trades are then recorded as transfers in the investors’ accounts with the depository. This lowers transaction costs and increases security. Delivery versus payment describes a settlement process whereby securities are transferred against receipt of cash, frequently through a dematerialized settlement system. Real-time gross settlement refers to a process whereby the seller receives payment at the exact time the trade settles so that the buyer must have funds available for each purchase (see Chapter 8, Developing a Government Securities Settlement Structure).
In the United States, the municipal bond market is characterized by a wide array of internal and external credit enhancement structures, including refunded bonds (which are bonds that have been refinanced with an amount invested in government bonds held in escrow to meet all remaining payments), insured bonds (where an insurance company such as the Financial Guaranty Insurance Corporation [FGIC] or the Financial Security Assurance [FSA] guarantees the principal and interest on the bonds), and bonds backed by letters of credit or other forms of credit enhancement from banks.
A “structured bond” is a generic term referring to any obligation other than a conventional general obligation bond. Structured bonds include asset-backed or insured obligations, revenue bonds and other forms of limited recourse financing, and bonds incorporating derivatives. The term “structured” implies that the instrument encompasses a degree of “financial engineering.”
The practices for public offerings and private placements, whether best efforts or bought deals, are essentially the same. A private placement may or may not be listed.
Such systems (e.g., Blue List and Munifax) are used in the United States to support placement and sale of subnational bonds. Indonesia and Poland have given particular attention to rules for listing bonds on their stock exchanges, but any impact on secondary markets in these countries is not yet apparent. See Leigland 1997.
See Leigland 1997.
Centralized market supervision is supervision by a statutory body with purview over a broad range of financial activities and instruments, such as fixed-income and equity markets, derivatives, and futures.
Another informal association, the Government Accounting Standards Board (GASB), promulgates voluntary accounting standards. Neither the MSRB nor the GASB have the legal authority to mandate changes in management of the municipal bond market. This function remains under the authority of the SEC.
Chapter 9 of the United States Bankruptcy Code refers to the bankruptcy of municipalities. The application and interpretation of this law has been fraught with difficulties, including conflicts with the 10th amendment to the U.S. Constitution (which establishes state sovereignty) and disagreements over the definition of municipality.
One example is Hungary, which introduced such a bankruptcy law in 1995. Since the law was introduced, eight small cities have gone through the procedure and are now in stable financial condition.
U.S. cities, such as Philadelphia and New York, have received support from the state rather than the national government.
See Fortune 1991.
In Colombia, ratings from nationally recognized credit-rating agencies are required for regulatory purposes, while in Argentina ratings are voluntary and are used as a disclosure gesture. In Hungary, ratings from domestic rating agencies are required for public issues but not for private placements on the domestic market.
This practice has been particularly common in the United States, where monoline insurance companies, such as AMBAC (American Municipal Bond Assurance Corporation), FGIC, and FSA, have specialized in guaranteeing municipal debt issues, complementing the credit support provided by commercial banks through letters of credit.
For example, during the financial difficulties of Philadelphia, bond insurers are understood to have played a major role in encouraging the intervention by the state of Pennsylvania.
An irrevocable letter of credit is a form of guarantee provided by a bank that is provided to the trustee for a bond issue so that the bank is required to pay principal and/or interest in the event that the issuer should fail to do so. Such an instrument is termed “irrevocable” if the bank is obliged to make such payments regardless of the financial condition of the issuer.
Subnational bonds are eligible for rediscount facilities at central banks in many countries, including, for example, Argentina, Brazil, and India. These rules, however, are subject to ongoing review.
In some developing and transition countries, intermunicipal undertakings have the potential to become important borrowers.