Industrial Policy and Risk Sharing in Public Development Banks: Lessons for the Post- COVID Response from the EIB and EFSI

The European Investment Bank (EIB) and European Investment Fund (EIF) have been key partners in implementing the Juncker Plan (EFSI) (2015–2020), which aims to increase lending to economically or socially valuable projects too risky to receive private finance through leveraging scarce budgetary resources, and going forward will play an important role in the EU’s post-COVID industrial policy response. In order to evaluate these initiatives, we: 1) distinguish between “real economy” risks arising from natural uncertainty relating to investments in certain types of projects or sectors and “financial” risks that are related to financial products or intermediaries themselves, and create the danger of subsidising the profits of private investors while socialising their risk of losses; and 2) outline the trade-off between increased leverage and policy steer and control over projects due to the number of intermediaries involved, and the need to make projects attractive for private investors. We argue that EFSI has made significant achievements, including enabling the EIB and EIF to provide long-term finance in the post-crisis period and to take more “real economy” risk, leading to valuable investments that would otherwise have not taken place. However, member states’ budgetary constraints have created incentives for EFSI to focus excessively on increasing leverage, at the expense of policy steer. Furthermore, the use of complex financial products and opaque pricing methods with terms too generous for private investors has in some cases generated excessive “financial risk” at the expense of “real economy risk”. In order to increase investment in the real economy and play a role in structural transformation, the EIB’s post-COVID response must have a greater focus on the final beneficiaries of projects rather than on the private financial intermediaries themselves. In those cases where it is necessary to use intermediaries, performance related conditionalities should be strictly enforced to have greater control over projects. 1 We would like to thank Helen Kavvadia, Matthias Thiemann, Daniel Mertens, Camila Villard Duran and Peter Volberding for comments on earlier drafts. We gratefully acknowledge financial and intellectual insights from FEPS, especially from Laszlo Andor and David Rinaldi Page 1 of 26 Industrial policy and risk sharing in public development banks: Lessons for the post-COVID response from the EIB and EFSI – Stephany Griffith-Jones and Natalya Naqvi © July 2020 / GEG WP 143 The Global Economic Governance Programme University of Oxford Page 2 of 26 Industrial policy and risk sharing in public development banks: Lessons for the post-COVID response from the EIB and EFSI – Stephany Griffith-Jones and Natalya Naqvi © July 2020 / GEG WP 143 Table of contents Introduction 3 I. A framework for evaluating risk sharing in public development banks 4 II. The EIB, EFSI and InvestEU 6 III. Instruments used in EFSI 10 IV. Relationship with financial intermediaries and private investors 17 V. Conclusion: Achievements, risks and lessons for the EIB’s post-COVID response 22 References 24 List of interviews 26 The Global Economic Governance Programme University of Oxford Page 3 of 26 Industrial policy and risk sharing in public development banks: Lessons for the post-COVID response from the EIB and EFSI – Stephany Griffith-Jones and Natalya Naqvi © July 2020 / GEG WP 143 Introduction In the wake of the financial crisis of 2007/09, and the Eurozone debt crisis of 2009/10, there has been renewed support for public regional and national development banks, as the limitations and problems of a purely private financial sector have become more evident to different strands of economic thinking (Griffith-Jones and Ocampo, 2018). In this context, the European Investment Bank Group (EIB), with its long track record of successfully playing a key and large role in funding intra-European infrastructure, including renewable energy, SMEs and innovation, has taken on renewed importance. The EIB and European Investment Fund (EIF) have been key partners in implementing the post-crisis Juncker Plan (EFSI) (2015–2020), a EUR 33.5bn guarantee from the EU and EIB budgets, which aims to increase lending to economically or socially valuable projects too risky to receive private finance through leveraging scarce budgetary resources. Following the 2020 COVID crisis, the EIB plans to take an important role in the joint EU Response package, including through its implementation of an expanded InvestEU guarantee of EUR 75bn which reportedly aims to mobilise a preliminary estimate of EUR 1000bn in investment, and creation of a new industrial policy oriented strategic European investment window2. In order to evaluate the EIB’s activities under EFSI and draw lessons for its response to COVID, we distinguish between “real economy” risks arising from natural uncertainty relating to investments in certain types of projects or sectors and “financial” risks that are related to financial products or intermediaries themselves, and create the danger of subsidising the profits of private investors while socialising their risk of losses. We then outline the trade-off between increased leverage and policy steer and control over projects due to the number of intermediaries involved, and the need to make projects attractive for private investors. We argue that EFSI has made significant achievements, including enabling the EIB and EIF to provide long-term finance in the post-crisis period, and to take more “real economy” risk, leading to valuable real economy investments that would otherwise have not taken place. However, member states’ budgetary constraints have created incentives for EFSI to focus excessively on increasing leverage at the expense of policy steer. Furthermore, the use of complex financial products and opaque pricing methods with terms too generous for private investors has in some cases generated excessive “financial risk” at the expense of “real economy risk”. In order to increase investment in the real economy and play an effective role in European industrial policy, it is important that the EIB’s post-COVID response has a greater focus on the final beneficiaries of projects rather than on the private financial intermediaries themselves. In those cases where it is necessary to use intermediaries, 2 https://ec.europa.eu/commission/presscorner/detail/en/qanda_20_947 The Global Economic Governance Programme University of Oxford performance-related conditionalities should be enforced to have greater control over projects. The paper proceeds as follows. In part I we outline an analytical framework for evaluating these initiatives. In part II we give some background on the EIB’s historical evolution before discussing its post-2008 activities. In part III we detail EFSI’s leverage mechanism and the instruments and financial products it uses, in order to illustrate the tradeoffs between financial and real economy risk, and leverage and policy steer. Finally, in part IV we discuss the distribution of risks of losses and profits between public and private actors and put forward a framework by which to assess the consequences of risk sharing arrangements. We conclude by discussing the implications for the EIB’s post-COVID response. I. A framework for evaluating risk sharing in public development banks In evaluating the types of instruments these initiatives use to finance investment, two related issues emerge. The first concerns the types of risks various instruments entail for the public sector. The second concerns the trade-off between increasing loan volume through leverage and policy steer3. Analytical framework for risk taking There is a key distinction on the nature of risk that is essential to clarify, both from an analytical point of view and a policy perspective. This should be important to evaluate initiatives like EFSI and InvestEU. There is first the “real economy” type of risks; these are basically related to the natural uncertainty related to projects or sectors. These are typical: 1) in infrastructure projects, as discussed for example in Griffith-Jones, 1993 (eg risks of construction difficulties and delays, especially in engineering ambitious projects, like the Channel Tunnel). We illustrate this in Box 1 below, with an offshore wind example, funded by EFSI; 2) Such “real economy” risks are also very prevalent in the funding of innovative companies, such as start-ups, often based on potentially excellent ideas, but lacking assets for guarantees and/or track record; 3) Financing of SMEs is generally considered more risky in most countries, except in countries – like Germany – with very decentralised banking systems, which allow for a greater knowledge of companies, thus reducing asymmetries of information (Stiglitz and Weiss, 1981), and a long tradition of broadly successful lending to SMEs. SME financing becomes more risky if financial crises happen, when the benefits of diversification are reduced; 4) Very importantly, “real economy” risks can also relate to sectorial or crosssectorial innovation that may lead to major increases in productivity and/or significant 3 Because EFSI is recent, and because many of the projects have long maturities, the full impact of which will only be known in longer term, it is hard to determine concretely at this stage what the full economic and budgetary implications are. Nonetheless, in this paper we attempt to delineate a framework for assessing likely results. Page 4 of 26 Industrial policy and risk sharing in public development banks: Lessons for the post-COVID response from the EIB and EFSI – Stephany Griffith-Jones and Natalya Naqvi © July 2020 / GEG WP 143 The Global Economic Governance Programme University of Oxford Page 5 of 26 Industrial policy and risk sharing in public development banks: Lessons for the post-COVID response from the EIB and EFSI – Stephany Griffith-Jones and Natalya Naqvi © July 2020