Uncanny resemblance: Greedy bankers and critics of PPPs

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Normally critics of the private sector like disparaging the greed of bankers. Many bankers in turn take a dim view of people who do not see the value of endeavors involving the profit motive. Yet, as the French say: “Les extremes se touchent” – sometimes extreme views have more in common than they care to admit.
In one such case, both bankers and critics of public-private partnerships (PPPs) are happily united in dumping risks on unsuspecting taxpayers – precisely the citizens whose interests they profess to serve. How so? 
Banks are unusual firms. They carry little equity relative to debt – often no more than five percent of total assets at best. Typical firms in other sectors would find such levels of equity positively dangerous. They often carry equity worth 50 percent of assets, many even more. 
Bankers say equity is expensive and debt cheap. Hence low leverage – little equity as a share of assets – makes sense. If that were it, firms other than banks would be fairly dim-witted. They should also load up on debt and thus lower costs. So why don’t they?
When a firm carries little equity, just a little bit of adversity risks wiping it out. Hence creditors would like to see more equity to assume risk. Why do creditors, including depositors, not take the same view of debt for banks? When banks fail and shareholders lose money, banks tend to get “bailed” out. There may be formal mechanisms like deposit insurance or informal de facto insurance by taxpayers. Often such insurance is not priced. 
Thus when banks fail, many types of creditors are held whole. Risks are shifted to taxpayers who get little or nothing in return. Debt for banks is thus cheap because the risk that should be carried by shareholders is shifted to taxpayers. If one were to price the de facto credit insurance that taxpayers provide the ostensible “cheapness” of debt would disappear and banks would start exhibiting equity levels like firms. 

That is what they did earlier in history, when tax-funded safety nets did not yet exist.  The arguments have been forcefully presented by Anat Admati and Martin Hellwig in the book "The Bankers’ New Clothes."
Meanwhile, over in the PPP corner of the world, critics allege that private finance unduly raises the costs of finance. Government finance would be cheaper. Indeed, the quoted rates on government debt backed by the sovereign tend to be lower than for firms from the same jurisdiction. Why is that? Is it that governments are better at managing risks and therefore creditors give them lower rates? Hardly. 
When projects funded with government debt fail, creditors are typically still repaid. Who pays? Not the revenues of the projects, but taxpayers who are instead called upon. If one were to value the implicit credit insurance provided by taxpayers, the ostensible systematic advantage of government finance would vanish.
Wait a minute, say many economists. The government may have an advantage at bearing risk. A prominent article by Arrow and Lind of 1970 sets out conditions under which the government can diversify the risk borne by taxpayers so as to make it negligible.
What does it take? First, projects need to be small relative to national income (GDP). Second, the project outcomes need to be uncorrelated with income. Third, there need to be very many taxpayers each shouldering a tiny bit of risk. 
In practice these conditions tend not to hold. First, some PPP projects are sizeable relative to national income: for example, the Bujagali power project in Uganda, which cost some five percent of GDP. Yet, indeed, many projects are fairly small relative to income particularly in the health and education sector. 

Second, the economy is the sum of all projects. On average, projects must be correlated with national income – some more, some less. A lot of PPP projects, for example, infrastructure projects are justified precisely because they are supposed to drive overall economic development.  That means by design the projects are supposed to be strongly correlated with overall income. When that is the case, the risk borne by taxpayers constitutes a cost that cannot be ignored. 

Finally, in many countries, the number of taxpayers is limited and highly skewed, for example, the very rich may not pay a high effective tax. The emerging middle or lower class may be unduly taxed. This raises the cost of risk bearing from a social perspective.
Taking all of this into account wipes out the ostensible systematic advantage of government finance. For the best statement of the argument, look no further than recent work by Christian Gollier, the head of the Toulouse School of Economics and Luc Baumstark.  A short article sets out the core arguments. 
For governments wondering how to deal with this practically, the best report has been prepared for the French Prime Minister under the stewardship of Christian Gollier.
Time to brush up on French, where “les extremes se touchent”!     

(Editor's note: the observations and opinions in this blog post express the individual views of the author, not the World Bank Group.)


Michael Klein

Professor, Frankfurt School of Finance and Management

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