There are many forms of financial intermediation, but here we will look at the ones which are supported by the EIB. Like other IFIs it provides loans and investments to banks and investment funds who act as the intermediaries. These intermediaries are then required to on lend that money, usually in the case of the EIB with certain conditions attached. There are some uniform conditions such as a ban on certain sectors or the minimum and maximum loan size and there are also loan specific conditions which are negotiated individually (such as allocating the funding to a specific targeted sector). The EIB calls these loans ‘credit lines’ which are more commonly known as global loans.
Intermediated lending is increasing in volume. For the EIB, it now represents over 20% of their total annual lending and this figure is increasing. This is as part of a wider global trend of transferring more and more public money into private ownership. Both in 2008 and 2012 when the EIB was asked to increase its lending as an anti-crisis measure, it put a special emphasis on intermediated lending to reach SMEs.
It is increasingly used as a policy tool by the EIB to support key areas such as micro finance or renewables. The argument is that through intermediaries smaller loans and investments can be provided than the IFIs can provide and more businesses can thus be supported by the EIB than would otherwise be possible.
Definition of a financial intermediary:
A financial intermediary is best described as an institution which acts as a go between, channelling money between lenders and borrowers. This can be a commercial bank or another type of finance company (eg. an insurance or investment company) and even private equity funds. These private equity funds will typically borrow some of their funding from a bank (in this case the EIB) and then on lend or on invest into the business which they are targeting.
The main issues with intermediaries
- The whole process of how the intermediaries on lend or on invest the money is not transparent at all despite the fact that it is public money which is being handed out. Little or no information is provided to the public by the intermediaries or the EIB on where the money ends up and who actually benefits from it. This was recently shown in two reports which investigated the EIB’s funding of intermediaries, ‘Hit and Run Development’ which focused on the EIB’s involvement with African banks and equity funds and ‘Missing in Action’ which focused on the EIB’s global loans to intermediary banks in four Central and Eastern European countries.
- With the loans provided by the EIB to intermediary banks, it is these banks that seem to derive the most benefit from the funding rather than the end recipients who could arguably find the money elsewhere. The reason being that many of the alleged benefits of these loans are so small as to be marginal when compared to other non EIB backed bank loans to SMEs (eg. interest rate discounts of between 0.20% and 0.40% – so small as to be practically within the discretion of individual commercial bankers and certainly not reflecting the supposed financial clout and advantage which the EIB claims to bring to these loans – see ‘Missing in Action’ for further discussion) . Indeed, since the credit assessment of borrowers for these loans is entirely up to the commercial banks and using their own standard policies and guidelines, no special consideration is given to such borrowers. Thus those who qualify could very likely obtain the funding from the same bank (or its competitors) without the EIB’s involvement. The banks are often slow in handing the money out and don’t pass on the full financial benefit which they receive from the EIB. It would seem that they often use the money largely to prop up their capital needs.
- In the case of the EIB, the intermediaries take on the risk of the final loan or investment so they ultimately control the process of selecting and approving the end project. Despite certain conditions set down by these IFIs, the EIB has very little say in who the final beneficiaries of the loans/investments are.
- The EIB does not do any ex ante due diligence on the ultimate projects or benefactors of the money and very little ex post evaluation of them either. As a consequence it is impossible to evaluate the impact of these loans.
- There is often only a standard credit assessment done by the EIB of the intermediary banks or private equity firms themselves before they lend to them or invest in them. As outlined in the ‘Hit and Run Development’ report in politically weaker states or jurisdictions this can result in IFI money ending up in the hands of corrupt officials or cronies linked to dictators. Ex-post assessment is practically non existent
- When it comes to the global south, the intermediaries are mostly foreign owned and based entities so their local expertise and commitment to local development needs is highly questionable.
Although the EIB often designates the money it lends out to intermediaries for targeted areas such as renewable energy, due to the lack of transparency in intermediated financing, it is difficult to ascertain how much of this money actually ends up in such projects or indeed what kind of projects the IFIs actually allow under such a classification.
Specific issues with private equity funds
Definition of a private equity fund
A type of investment fund which invests its money in companies which are private (as opposed to public or stock exchange listed) or which it makes private once it invests in them. The fund itself is also typically privately owned (as opposed to publicly listed) and this is where its name originated from – private equity referring to private money or investments. This point regarding the private ownership of the investment company and the target company is key since it allows greater freedom of action and less scrutiny (and transparency) in what the fund does. Private equity funds usually attempts to gain a controlling stake over the target company in order to restructure it or to implement its strategy for making a profit on its investment. There are a number of investment strategies which can be used by equity funds and a fund will typically specialise on exploiting just one of these, eg. a leveraged buy out, where the fund borrows heavily to acquire the target company, loading the debt on to it and then seeking repayment of the debt and its investment through restructuring of the company, asset sales or cost cutting and eventual ‘exit’ of the investment (listing the company on the stock exchange or selling it in a private sale). Private equity funds vary how long they hold an investment but typically on average its 5-7 years. As part of its strategy, a fund will diversify and spread the money it has between a number of investments at the same time. The most common investors in private equity funds are other investment firms (hedge funds, pension funds etc…) and wealthy ‘high net worth individuals’.
- The funds are mostly domiciled in tax havens and so the home state where the investment is made misses out much needed tax revenue.
- There is a real issue with private equity as a model used by the EIB to support development since this type of finance is not development orientated but very much profit driven. Equity funds have a very short time frame for investment (the majority of all private equity investments are held for an average of 5-7 years). The sole motivator of the funds is an appropriate return on their investment so whatever is necessary is done to achieve this and if it is not possible then a quick exit (sale) is arranged.
- The private equity investment model seeks to maximise profit through any number of drastic means such as loading up the project/business with excessive debt, restructuring the business entirely to exploit any advantages within it, drastic cost & staff cuts, selling off components of the business to extract ‘value’ (get money back). This is obviously counterproductive to the development needs of the states and economies involved.
Why does the EIB lend in this way?
- It enables them to have a wider reach – to lend to more projects much smaller amounts of money than they would otherwise be able to do. The EIB threshold for standard project funding is EUR 25 million while the global loans it provides through intermediary banks can be as small as EUR 40,000. It would be unworkable for the EIB in its current structure to start processing and lending out such small sums.
- It reduces their transaction and administration costs by lending one large amount rather than many small ones.
- It supposedly enables local experts (i.e. the intermediaries) to best on lend or invest the funds based on the local situation and demand.
- Supports local finance sector, i.e. the banks and the equity funds. In reality however, these are often foreign owned or subsidiaries of such banks so support is really to the parent company and not the local sector.
- Enables the EIB to specifically target and support projects in particular sectors such as SMEs or Research & Development at a much smaller size in order to stimulate these sectors. It does this by designating an entire intermediated loan as R&D, or micro or other. So basically the EIB uses intermediated loans to fulfil a political policy objective which it has been given. Another popular policy objective is strengthening and support of the private sector which virtually allows for any kind of project to be supported by this kind of loan or investment.
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