Building smart cities takes money. Upgrades to infrastructure, technology and operations don't come cheap.
One time-honored mechanism used by local governments to finance these type of improvements has been municipals bonds. But a number of cities and public institutions are now challenging that tradition and turning to banks for direct loans.
The dramatic drop in municipal bond issuance over the past seven years is well documented by bond market watchers. Industry experts note that state and local governments issued $429.3 billion of debt in 2007. By 2011, the volume had plummeted to $294.7 billion. Through the first half of 2014, bond issues had totaled a mere $151.6 billion.
This decline is partly attributable to the recent recession and reluctance or inability of municipalities to take on debt. But it also clearly correlates to a rise in direct loans from banks to public agencies. In some cases, banks have actually initiated contact with municipal borrowers.
Citing a recent Moody's Investors Service report, Governing notes that bank municipal holdings moved from $225 billion at the end of 2009 to $425 billion in securities and loans today. That means that banks almost doubled their municipal loan portfolios over this period. The example of Cook County, Illinois echoes that trend. The county's bank debt has grown from about $130 million a few years ago to $370 million today.
Still, because direct loans are pretty much unregulated, it remains difficult to gauge exactly the scope of the shift from bond to bank financing. Standard & Poor’s estimates that direct bank loans to muni issuers amounts to about 20% of new municipal borrowings.
Direct lending pros and cons
Why are local governments seemingly eager to borrow directly from banks? The low interest rate environment partly explains it. Banks have been able to offer competitive rates to municipal borrowers on both tax-exempt and taxable debt. So local governments have prudently seized the opportunity to refinance outstanding bond debt on more favorable terms.
In addition, bank loans and personal loans present fewer regulatory hurdles and lower transaction costs. Cities, counties and other public institutions avoid rating agency fees, underwriter’s counsel fees, re marketing agent fees, liquidity provider or other credit enhancement fees, bond trustee fees and bond trustee counsel fees. A recent article in the Pennsylvania Bankers Association magazine outlines some more nuanced reasons as well.
It’s also important to acknowledge the obvious here: Banks, unlike bond issues, don’t require voter consent for cities to take on public debt. While that helps streamline the lending process, it raises a flag around the question of public disclosure. The lack of transparency around direct bank loans particularly annoys credit rating agencies and investors that are trying to perform risk assessments related to local government operation.
Another catch with direct loans is that banks tend to avoid taking on the long-term variety that are necessary for large infrastructure projects. Unless projects are implemented and funded in phases, issuing municipal bonds likely remains the best financing option.
To get a comprehensive picture of finance options available to cities today, download our Smart Cities Financing Guide. It’s free when you register (also free) for SCC membership.
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