Could a national investment bank support recovery from the Covid-19 crisis?

The unprecedented challenges brought by coronavirus will require an investment-led recovery at a time when confidence in the economy is weak. The establishment of a national investment bank could foster a more positive climate for growth, promoting innovation, employment and improved productivity.

Defining and delivering on development goals is important when responding to a crisis – clear aims help countries both to accelerate their action and to ‘build back better’, ensuring that the economy advances as it recovers. Rising to this challenge relies on investment: the ecosystem must draw through investment commitments, innovation and funds from both private and public sectors.

National investment banks (NIBs) have the potential to help greatly here by fostering a positive policy environment, bringing forward new projects, and managing and sharing risks.

What role does a national investment bank (NIB) play?

History shows that government actions taken immediately after a pandemic or war can be more important to growth and development than what happens during the crisis. Crises change the needs and wants of the public, and the priorities of government. Whatever the post-crisis goal a country may have, a NIB is one way to deliver funds and expertise.

There are various models of NIB, but the foundational differences with private sector banks are that governments are the major or sole shareholders and, if well designed, the NIB will have a longer time horizon and a broader range of instruments and objectives. This means that its mandate and investment aims differ from private sector lenders, often linked to the health of the overall economy, or a sector, rather than in providing dividends to shareholders. The ideal NIB is well run and profitable.

The UK would seem a good candidate for a NIB. The government has several clear development goals: it is strategically committed to improving productivity and infrastructure, ‘levelling-up’ and the transition to an economy with net-zero emissions of greenhouse gases. These can involve complex projects and programmes, which are likely to feature public-private partnerships, and to face financial and political risks.

The concern is that the risks might be too large or too difficult for commercial banks to handle. Proponents of NIBs suggest that they can overcome market failures by reducing, managing and sharing risks, working to improve the investment climate, and fostering key aspects of collaboration in bringing projects through.

Furthermore, by turning over their portfolios of loans, NIBs can generate private investment and finance so that government intervention of this form supports the private market. Thus, they can help go to scale in real time at critical periods for the economy, and do it in a way that enables and spurs private sector investment, innovation and finance.

What does economic research tell us about NIBs?

NIBs have a rich history. The idea of government-owned banks dates back at least to the 19th century with Belgium pioneering the concept of ‘universal banking’ through the establishment of the Société Générale de Belgique, a national bank, which played an important role in the Industrial Revolution. In the mid- to late 19th century, German universal banks played a significant role in the industrial development of Germany (Tilly, 1998).

But even before then, the Medici banking empire played an important role in the economic advance of 15th century Florence. In the Roman empire, ‘mensarii’ acted as public bankers in war or crisis to help citizens deal with financial stress. And there appears to have been related public or nation-focused banking activities still earlier – for example, in ancient Egypt and China.

John Maynard Keynes, who conceived the plan for the establishment of the World Bank, introduced the idea of ‘paid-in versus callable capital’. Under this system, a bank has some capital paid in directly and a further amount, say three or four times paid-in capital, is callable if necessary. This helped to ensure low borrowing rates for the World Bank, allowing it to play a key role in global development. The World Bank typically has a very conservative lending ratio, often with total outstanding financing no larger than the total of paid-in and callable capital.

Yet there are divergent arguments in economics on the effectiveness and social desirability of government-owned development banks. The ‘constructive’ view emphasises that these banks can advance welfare-enhancing investment plans in several ways:

Coordination failure: This arises because of the complex nature of development projects, the early stages of which require the cooperation of many actors. The NIB, which acts as a trusted convener with a good range of financial instruments (including equity, long-term loans and guarantees) can help to join the dots.
Market failure and misallocation: This arises when markets fail to provide finance to particular sectors or regions, despite there being opportunities that would be welfare-enhancing for the economy (Atkinson and Stiglitz, 1980; Stiglitz, 1993).
Short-termism: This arises when managers of financial firms (or other companies) forgo investments that pay off in the longer term by prioritising short-term returns, often motivated by the need to provide shareholder dividends. At its root, this problem is often caused by managerial compensation arrangements, which motivate near-term shareholder dividends rather than long-term value (Miles, 1992; Davies and Haldane, 2011). A NIB can help to avoid these problems.
Pro-cyclicality: This problem occurs when the financial sector is damaged by a crisis and is unable to provide the funds to an economy as it heals. The result is that the financial sector intensifies slumps (and booms) rather than smoothing them out (Borio et al, 2001). A NIB, backed by the sovereign, may help to offset this.

In contrast, the ‘negative’ view stresses resource misallocation and inefficiencies, including:

Agency issues: These can arise because of conflicts of interest between government and those managing the NIB. The managers might shy away from risky lending to avoid the blame of getting non-performing assets on their balance sheet. In other cases, government might be focused on the perceived benefits of large investments and push for lending while failing to take sufficient account of risk and cost. Managers or government can also be limited in their ability to understand or manage risk and cost (Bernheim and Whinston, 1986; Banerjee, 1997).
Political distortions: Politicians can use government-owned banks to gain electoral advantage and personal monetary benefits through corruption. In economies with low public accountability and low judicial independence, these banks can be used as channels to siphon off public funds through cheap lending to specific groups of voters and well-connected elites, or to facilitate bribery (Shleifer and Vishny, 1994; Perotti and Vorage, 2010).

International lessons

There are many examples of international and national development banks that have performed well, including the World Bank, the European Bank for Reconstruction and Development (EBRD), the International Finance Corporation (IFC) and the European Investment Bank (EIB).

At their best, such institutions have helped to foster investments, innovation and development – and they can help with recovery. For example, the EIB, which has played a strong role in infrastructure in Europe and beyond, will be a powerful element in the European Green Deal, announced in December 2019, in the seven-year European Union (EU) programme and budget of July 2020, and in the July recovery programme of 2020.

At a national level, countries have established their own versions of NIBs, including Kreditanstalt für Wiederaufbau (KfW) in Germany and Caisse des Depots in France. KfW, which was established in 1948 and is jointly owned by the Federal Republic of Germany (80%) and the states of Germany (20%), is primarily focused on Germany, but it also works on global economic, social and ecological development through its presence in Africa, Asia, Latin America and south-eastern Europe. KfW has been assisting Germany’s federal government in achieving its development and international cooperation goals by financing investments and reform programmes in various sectors, including health, education, energy, and business and finance.

Experience has not always been positive. There are important examples of NIBs that have exhibited corruption, cronyism or simply inefficiency and wasted resources. For example, the Brazilian Development Bank has been accused of systematically providing more capital to big firms with political connections and also violating ethical and environmental principles in its operations (Lazzarini et al, 2011). Nevertheless, it has played an important role in developing Brazil’s infrastructure.

Overall, the international lessons are that success rests on careful policy design and good management. The mandate from government to advance development must be clear with specific definitions. Operating principles should be robust and implemented rigorously. Specifically, these operating principles should embody, for example, sound banking (in terms of risk and return); ‘additionality’ (making loans to projects for which the private market, by itself, is not ready to provide funds); and development impact (based on clear criteria).

Other important factors include an independent board, staff members with banking skills, and a range of instruments (loans, equity, guarantees, etc.). When these conditions are met, the evidence is that a NIB can make a major and constructive contribution to economic development.

Evidence also suggests that the UK should be able to make a new NIB work. Based on the five high-level ‘principles of democracy’ measures published by the Varieties of Democracy (which capture electoral, liberal, participatory, deliberative and egalitarian dimensions), the UK has been consistently ranked as a top performer among the 202 member countries. The UK has a strong tradition in respecting the rule of law and building effective independent institutions that are transparent in operation and accountable to parliament. It has hosted and participated strongly in the EBRD.

What is the case for a NIB in the UK?

The case for a NIB is longstanding but it has arguably moved further in recent years and months. Following the 2008 financial crisis, the LSE Growth Commission argued that a new institutional architecture was needed to drive stronger private and public investment in the UK. It proposed a system with three pillars:

Government – the Treasury, the Department for Business, Energy and Industrial Strategy and local government – setting policies and the investment climate.
An Infrastructure Commission.
The creation of an investment bank.

These three pillars could combine to anchor investments in medium- and long-term strategy, and could help to deliver inclusive and sustainable growth, resilience and the net-zero emissions target, and support skills formation and technological change. The government acted on the second of these pillars by creating the National Infrastructure Commission. We can now also see, in the context of Covid-19, the potential role in crisis and recovery.

The third pillar is yet to be built, and the UK lacks a large-scale NIB. The potential contribution of the existing British Business Bank is valuable but limited. It is focused on small firms, which are important of course, but not well structured for scale or counter-cyclical action. In leaving the EU, the UK will lose access to the EIB, thereby further strengthening the case for a NIB in the UK.

One of the major factors in the poor productivity performance of the UK relative to other advanced economies has been the weakness of private sector investment, which is lowest for the UK, as a percentage of output, among the G7 countries (Nabarro and Schulz, 2019). A new NIB would be tasked with increasing the quantity and quality of investment and innovation. Its purpose would be to enhance investment and innovation (both quantity and quality) by performing the following functions:

Reducing policy risk: Acting as a co-investor to offset the risk that government priorities or policies can change. This can help to build confidence by being seen to strengthen long-term commitments by political decision-makers that can be sustained across electoral cycles and ministerial appointments.
Reducing private sector risk and cost: Working with local and national government, the bank could help to establish long-term revenue streams to match long-term investments and activities, taking account of externalities.
Preparing large-scale projects: The NIB would support activities from large complex projects to ‘aggregation models’, such as retrofitting or replacing gas boilers across neighbourhoods. It can create platforms for scale across the economy and help to set new examples and facilitate their multiplication. This is also important in supporting green innovation and job creation.
Overcoming early-stage risk: Building partnerships, acting as a trusted convenor in project design and implementation; and helping projects get off the group by bringing together relevant parties from both local and national politics, the public and private sectors.
Sharing and allocating risk: By constructing investment plans and assets to match the risk appetite, capability and balance sheet of different institutions, it can manage risks.

If a NIB were to be set up in this way, experience and evidence suggests that it could provide a coherent and strategic platform, foster project development, create a positive investment climate, and reduce and manage risks. Thus, it can strongly enhance private sector investment and generate private finance.

Should NIBs be part of government or independent?

One vital question is the degree or independence from government. Since the UK government itself is a large-scale investor and project manager, one benchmark would be to make the NIB wholly government-controlled. Would a NIB perform all these functions effectively and efficiently if the NIB were ‘in-house’ within a government department? There are a number of problems here that suggest an ‘arm’s-length’, functionally independent NIB would be better, including:

Skills and staffing: To be successful, a NIB needs a staff with the right skills and experience. Banking is a profession requiring qualifications, training and expertise. These are generally not present at sufficient scale in the civil service.
Balancing political priorities with sectoral expertise: Senior decision-makers within the NIB will need expertise related to sectors and development aims. Politicians would set the mandate and framework as they have in other independent institutions, such as the National Institute for Health and Care Excellence, the Bank of England and the Office for Budget Responsibility. But the decisions are taken by specialists, with politicians absolved from the need to sign off on every project.
Devolved decision-making: Since government is clear that levelling-up is so important in the UK, a NIB built to foster devolved decision-making away from Whitehall would have real advantages. Such a NIB would support initiatives in the regions tailored to address local needs.
Transparency, accountability and governance: The political cycle itself can be a source of market failure and short-termism. Placing the NIB outside a central government department would reduce day-to-day political interference and the risk of actions taken for narrow political advantage. Transparency is crucial here so that the accountability of a NIB can be clear and strong to parliament and the country.

By enabling both private sector and government to work more effectively and efficiently, a NIB can have a powerful impact in relation to national strategies, including by understanding and taking account of spillovers and externalities flowing from investment, especially in infrastructure. This is particularly important for green investments, as was previously shown by the Green Investment Bank, which, for example, was a strong driver for the successful development, going to scale, and large cost-reduction of offshore wind energy projects.

The NIB could foster and enable investments that are crucial to levelling-up strategies and the cohesion of the UK. It could also play a role in operating counter-cyclically, thereby helping to reduce unemployment and improve macroeconomic stability. Institutional support from the NIB could strengthen the position of government for taking a long-term perspective on economic development.

How could a NIB aid the UK’s recovery from the Covid-19 crisis?

The unprecedented challenges brought by the Covid-19 outbreak will require an investment-led recovery at a time when confidence in the economy is weak. There is uncertainty about the economic outlook and many firms have impaired balance sheets.

The government has been able to provide liquidity access to businesses, for example, through the Coronavirus Business Loan Scheme and the Bounce Back Scheme, along with supporting workers through the job furlough scheme. Nevertheless, output remains well below its pre-crisis level, with the Treasury understandably worried about the mounting debt burden. To help to jump-start large-scale investment, the UK would benefit from a resilient financial institution that can both finance investment for the medium and long term and take counter-cyclical actions.

The case for the third pillar from the recommendations of the LSE Growth Commission is even stronger today given the Covid-19 challenges in driving the economy forward in a sustainable way and creating confidence in a new growth path that can foster investment and employment. The wider context is one where the UK faces substantial productivity challenges – both compared with other leading economies, such as France and Germany, but also due to the sluggish productivity of recent years. Creating a positive investment climate, for both public and private investment, is key to meeting these investment and productivity challenges and to the competitiveness of the UK.

Overall economic evidence and international experience point to shortfalls in the UK financial sector’s ability to create sufficient innovation and investment to drive strong growth and support of key development goals. Establishing a NIB is a way to work alongside and foster the private sector to reduce, manage and share risks, thereby lowering the cost of capital and ‘crowding-in’ (rather than squeezing out) private investment and private finance. In this way, a NIB could reduce early-stage risks in large projects, help to overcome key market failures and pursue national objectives at a crucial moment in UK history.