Infrastructure Finance Mathias Dewatripont ECARES, Université Libre de Bruxelles and CEPR New Delhi – December 5, 2006

Introduction Part I: Discuss incentive issues in dynamic borrower-lender relationships and how they relate to infrastructure finance. Part II: Given the important role of banks in infrastructure finance, discuss issue of banking supervision.

A simple setting Investment project that costs I at date 0 and either gives G > I (in discounted terms) at date 1 (“good project”), or 0 at date 1 but, at additional cost of I (in discounted terms) spent at date 1, B > I (but < 2I, so “bad project”) at date 2. A profit-maximizing funder knowing project quality would like to fund only good projects; however, if I is sunk, once funding has started, funder would like to refinance bad projects!

A simple setting (2) With adverse selection, both projects funded provided bad ones not too numerous. However, if bad entrepreneurs ask for initial fun- ding only if expect refinancing, funders would like to commit to harden budget constraints! One credible way of doing it: Lower B below I, e.g. by having less intensive monitoring, e.g. though decentralized/market finance (as opposed to bank finance).

A simple setting (3) Hard budget constraints come however with two side-effects: 1.Can lead to short-termism: What if there is a “good long-term project”? 2.Is better at fostering innovative experimentation. This consistent with performance of USA versus Japan/Germany/France, given their different financial systems. Implication: Sectorally, ‘one size does not fit all’!

Lessons for infrastructure Not surprising that bank finance important. Be aware of soft-budget-constraint problems, with State-owned banks but also (even if less so) with private banks: validates the idea that privatization is not a panacea. Can be mitigated through: (i) having syndicated loans; (ii) proper banking behavior: competition and supervision (including market-based monitoring).

Banking supervision Nonfinancial firms typically have equity control in good times and debt control in bad times. Financial institutions lack that, due to small uninformed debtholders (depositors, insurees, …). Moreover, important to avoid bank runs, so deposit insurance very important, at least for households. But need to ‘make up’ for this lack of discipline.

Banking supervision (2) Key is to make sure bank management is stopped in bad times. Therefore, Basel-style regulation does make sense: Have regulator control when capital ratio becomes too low. Question of credibility in ‘bad macroeconomic times’ (where it is moreover too tough: pleads for cyclical deposit insurance contributions by banks).

Banking supervision (3) Market-based discipline does make sense: Ratings, risk-sensitive deposit insurance, big private subordinated uninsured depositors/debtholders. Don’t make the system too complex though (‘Basel-II curse’). Moreover, not a substitute for regulatory intervention: When the bank becomes insolvent, shareholders and subordinated debtholders have an incentive to gamble for resurrection!

Conclusion Keep in mind the need for a ‘flexible financial architecture’ to accommodate the needs of projects with different degrees of uncertainty. For projects that require bank finance, be aware of soft-budget-constraints problems and try and mitigate them through a combination of market- based discipline and credible regulatory intervention.