LIIT Structure

The Development of Non-bank Financial Institutions in Ukraine 87

Political Risk Insurance (PRI) and/or Partial Risk Guarantee (PRG) facilities to cover sovereign breach of contract risk: To address weaknesses in contract enforcement at the sub-sovereign level, the proposed PPP framework would integrate a political risk insurance (PRI) or a partial risk guarantee facility (PRGF) to cover private investors in local infra-structure utilities against breach of contract by sub-sovereign authorities.

At the sub-sovereign level, the choice between the two types of instruments is governed by the policy risk profile of the sub-sovereign involved in the contractual relationship with the private investor. At one end of the spectrum, policy risk enhancement instruments may not be needed in the case of sub-sovereigns at or above investment grade. In the middle are sub-sovereigns with intermediate policy risk profile in which case third-party policy risk insurance without sovereign counter-guarantee may be attractive. At the other end of the spectrum are sub-sovereigns with high policy risk profile, in which case third-party policy risk guarantees would not be attractive without sovereign counter-guarantees.

To cover transactions with sub-sovereigns with intermediate policy risk, a political risk insurance (PRI) facility without counter-guarantee from the Governmentincluding cover-age against sub-sovereign breach of contract risk could be established by an IFI.

The PRI Facility would be negotiated between the IFI and interested first-round pri-vate equity funds and second-round local infrastructure investment trust. Under the agreement, the fund/trust would apply for coverage for a specific risk or a combination of risks transaction by transaction, as needed. The coverage would apply in the case of an equity investment, or shareholder loan, or non-shareholder loan. Such coverage is also available for management contracts and many other forms of cross border investments, hence being a crucial element in the promotion of PPP. In addition, coverage may be pro-vided also if the project is supported by a subsidy scheme. In this case, the investors may want to cover the risk against the breach by the government of the obligation to make fund-ing available.

To cover transactions with sub-sovereigns with high policy risk profile, governments would establish a partial risk guarantee facility against sub-sovereign breach of contract riskwith counter-guarantee from the Government. Under this facility, an investor in a local infrastructure utility corporation issues a bond to finance the investment required to improve efficiency and/or reach environmental standards. The investor will be concerned about the sustainability of the operational and tariff policy agreements with the pertinent sub-sovereign authority, especially following any future changes of local administration.

Under the proposed facility, the IFI provides a partial risk guarantee (PRG) against the breach of the tariff policy agreement by the local authority. In the event the contract is breached and, as a result of this breach, the private investor is unable to repay the princi-pal of the bond at maturity or service loan principrinci-pal, the guarantee would be called. The IFI would make payment under the guarantee and then exercise a counter-guarantee with the central government. Finally, the central government would turn to the local sub-sovereign authority responsible for the breach and exercise fiscal transfer intercepts to recover the costs the central government incurred through exercise of the counter-guarantee by the IFI. Within this scenario, the investor would be protected against tariff policy agree-ment breach of contract, and the involved local authority is provided a strong incentive to honor its commitments.

The PRG facility would offer key advantages sought by many private sector investors as well as by local sub-sovereign authorities: (i) better financing terms through spread 88 World Bank Working Paper

reduction and maturity extension; (ii) incremental public debt at a fraction of capital investment leveraged; and (iii) better discipline of all involved parties. The PRG facility should be considered as a transitional solution to be implemented in an environment where there is progress in policy improvement and reform programs. Even so, the PRG model and its components should be designed carefully in a way to prevent moral hazard.

This can be done through structuring ex-ante and ex-post risk management mechanisms.

Ex-anterisk management mechanisms hinge on selective criteria that the local entities have to meet in order to access the PRG Facility and take advantage of its risk mitigation instruments. Localities have to meet precise positive criteria related to budget and bud-geting, tax, debt management, asset management and regulatory and contractual frame-work for local utilities (accreditation system).

Ex-postrisk management mechanisms are based on a quadrangular relationship between the IFI, the central Government, the local government and the investor in a local utility. The PRG is structured in such a way that incentives for maintaining contractual undertakings are maximized. Critical is the exercise of intercept power²⁵by the central Government in case a guarantee is called following local government in breach of contract. In this instance, the power of the Central Government is not only limited to the intercept of revenue transfer, but also to the intercept of tax shares, grants, dedicated revenue stream and seizing of accounts of localities.

Mortgage Insurance and Mortgage Securities Enhancement

As the Government moves to establish the legal, regulatory and institutional framework for the mortgage market, including the establishment of state registration for immovable property and state registration of mortgages, it could set its sights on the development of instruments to broaden access of lower-income households to the primary housing mortgage market and subsequently to support the development of the secondary mortgage market.

In this context, the Government may consider developing mortgage default insurance (MI) on the primary market, and subsequently developing enhancement instruments for mortgage securities.

Mortgage Default Insurance (MI).²⁶ Mortgage default insurance (MI) coves lenders and investors against losses resulting from borrowers defaulting on their home mortgages.

For direct lenders, MI can expand available credit for home-ownership by inducing more liberal lending criteria, usually in the form of a lower down payment requirement. For potential purchasers of residential mortgage loans or mortgage-backed securities, MI backed by sufficient risk capital can help provide the essential safety, liquidity, and investor confidence needed to make residential mortgages competitive with other instruments in the NBFI sector. Furthermore, to the extent that mortgage insurance becomes a critical link to accessing mortgage capital, the mortgage insurer may exert considerable influence on housing construction standards, property appraisal standards, loan documentation and data collection standards, and general credit and property underwriting standards.

The Development of Non-bank Financial Institutions in Ukraine 89

25. This section draws from Blood (1999).

26. This section draws from Chiquier, Hassler, and Lea (2004).

The existence of a fully functional primary mortgage market is on the critical path to the successful introduction of mortgage default insurance. Initial conditions include in particular: (i) economic and financial stability; (ii) legal and regulatory mechanisms to ensure contract enforceability; (iii) market and loan level experience data availability;

(iii) system for transferring, recording and establishing clear title to real estate; (iv) existence of institutional lenders competent in originating and administering home mortgage loans of investment quality (incl. property valuation and individual income and credit evalua-tion mechanisms and data); (v) funcevalua-tioning real estate markets, which capable agents and market data to serve buyers and sellers); (vi) effective banking regulation in place to assure the ongoing financial solidity of insured lenders and mortgage default insurers; and (vii) homeownership culture and commitment to repay financial obligations in the gen-eral population, along with acceptance of foreclosure in case of failure to repay mortgage debt.

The Government may consider alternative strategies to support the development of mortgage insurance in the country. On the one hand, it may decide to stay out of the mar-ket altogether. On the other hand, it may opt to support the development of mortgage insurance through some sort of Government sponsorship. Under the second alternative, a number of fundamental features would need to be considered:

(i) Shared credit risk with loan originators. The insurer needs to structure a form of coverage that entails the partial retention of risk by the lender, less moral hazard is generated and the lender may, over time, underwrite and transfer excessive risk to the insurer;

(ii) Full coverage to the secondary investor. Unlike the primary lender, the institu-tional secondary investor has no role in creating or managing the underlying credit risk and will have good reason to seek 100 percent coverage, the mortgage insurance 90 World Bank Working Paper