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Journal of Common Market Studies Vol. 33, No. 3
September 1995

The Public Policy Role of the European

Investment Bank within the EU

PATRICK HONOHAN*
The Economic and Social ResearchInstitute,
4 BurlingtonRoa4 Dublin4, Ireland

Abstract
Despite the increasing sophistication of private financial markets in Europe,
the European Investment Bank (EIB) has been expanding as never before. Is
the Bank just one among many large banks prepared to provide project finance
in Europe, or does it have a distinct public policy role? We argue that its main
distinguishing role to date has been to bring competition and efficiency to the
less efficient banking markets. But new initiatives envisage a move to more
EIB involvement in loan guarantees and equity investment. We review the
potential here and offer some cautionary remarks.

I. Introduction
Despite the increasing sophistication of private financial markets in Europe, the
European Investment Bank (EIB) has been expanding as never before. Its
balance sheet has more than doubled in six years and it is now lending close to
18 billion ECU per annum within the European Union (EU). This article asks
what the role of the EfBf is and should be within the Union. What distinguishes

*1 have benefited from discussions with officials of the EIB and the European Commission and from
interviews with some EB borrowers conducted as part of a study for the Commission. Two referees made
very helpful suggestions on an earlier draft.
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316 PATRICK HONOHAN

EIB lending from other financial intermediation in Europe, and is it performing

any role that distinguishes it from a privately owned bank?
Over the years, the hallmark of EIB lending has been its low-risk profile, and
the reliance placed on third-party, especially government guarantees. Owned by
EU Member States which do not receive dividends, the Bank has earned a
reasonable rate of profit on its, by now very substantial, equity: an average of
almost 1 billion ECU a year has been added to reserves. Its contribution to the
financial system is undoubtedly positive but, despite the emphasis given to the
Bank in the EU Treaties, there has been little overt evidence of it performing a
public policy role so far as lending within the EU is concerned. Its main
contribution has come through its readiness to provide project finance in regions
where the local financial market displays inefficiency, thereby placing local
banks under a constructive competitive pressure.
While local demand and supply conditions for long-term investible funds
appear relevant in influencing the country mix of borrowers, this mix is also
affected by the degree of efficiency in the local banking market. Although it helps
to compensate for some local deficiencies in financial markets, the EIB's
insistence on top-quality security amounts to a decision not to involve itself in
the evaluation and pricing of credit risks, often thought to be the hallmark of
financial intermediation.
Matters may be changing. Recent or prospective innovations, intended to
enhance the public policy role of the EIB, have included the establishment of a
new investment fund (EIF) in which the EIB will inject risk capital and which
will provide loan guarantees. Furthermore, while all lending is still guaranteed,
government guarantees account for less than two-fifths of new loans now. There
has also (for certain categories of project) been a relaxation of the ceiling on the
proportion of costs which the EIB will be prepared to finance.
To the extent that there is a more relaxed approach to guarantees and risk, it
may be argued that the EIB is beginning to take on a quasi-fiscal role, even
though explicit interest subsidies are still ruled out (except those administered
for the account of others). Though the reserves and capitalization of the EIB are
more than ample to carry some such cost, and while the scale is so far modest,
it will be important to keep track of implicit subsidies flowing in this way. The
intention is not to provide subsidies. If so, the public policy role will, once again,
be limited.
The article is arranged as follows: Section II describes the functioning of the
EIB and asks what its distinguishing features are. Section III discusses actual and
potential new departures in terms of risk capital and loan guarantees, and
assesses the potential for public policy benefits. Section IV contains concluding
remarks.

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 THE PUBLIC POLICY ROLE OF THE EIB WITHIN THE EU 317
H. The EIB and its Activities
Established by the Treaty of Rome in 1958, the ElB focuses on infrastructural
and other fixed capital formation within the EU. With gross lending commit-
ments of 17.7 billion ECU in 1993 (and net disbursements in excess of 10 billion
ECU), it is the premier long-term credit bank in Europe. The typical EIB loan is
long term, with maturity of between seven and 12 years for industrial borrowers
and up to 20 years for infrastructural projects. Interest rates have typically been
fixed for the maturity of the loan, but there has been an increase in the share of
variable rate loans and other more sophisticated instruments. The Bank requires
each loan to be backed by adequate security, typically a government guarantee
or that of a first-class private name.
The EIB also lends to non-Member States of the EU, including those in
eastern Europe and the Mediterranean region as well as the ACP states of Africa,
Asia and Latin America. However, this article concentrates on its activities
within the EU. The EU has other official lending facilities, including those of the
European Coal and Steel Community (ECSC); but the EIB has accounted for
about 85 per cent of EU official lending in recent years.
FinancialAspects
The EB does not pay dividends to its shareholders, and this dividend policy,
combined with the Bank's own statements to the effect that it is not a profit-
making institution, has sometimes led unsophisticated observers to suppose that
its lending may involve a subsidy. However, the Bank operates under statutes
which preclude such subsidy and examination of its accounts does not suggest
the existence of any hidden subsidies. In fact, the bank does make substantial
profits (1.13 billion ECU in 1993), and these have been retained over the years,
helping to build the capital and reserves of the institution to over 13 billion ECU,
or over 13 per cent of the total balance sheet.
The size of these profits reflects the loan pricing policy, which is to charge
borrowers a rate based on the Bank's own marginal cost of funds plus a small
spread to cover administrative costs. Thus, even though only five-sixths of the
lending is out of borrowed funds, the whole is effectively remunerated at a rate
reflecting the market yield on bonds. The fact that lending rates are not
differentiated by borrower might suggest a degree of cross-subsidization of less
good risks by better ones, but the strict requirements for security mean that the
differences in risk are probably minimal. Thus the profitability of the EIB is
broadly commensurate with its high capitalization.' Interest rates to borrowers
have not benefited.
IAs is confirmed by a comparison of key ratios from its profit and loss account with those of major banks
worldwide, cf. Honohan (1992). The return on equity has been of the order of 10 per cent - high enough to
ensure that there is no underlying cost to the tax-payer.
0 Blackwell Publishers Ltd 1995
318 PATRICK HONOHAN

The EIB has always required guarantees from first-rate guarantors for all
lending.2 Traditionally these guarantees have been mainly from EU govern-
ments, but the situation has changed rather rapidly in the last several years. As
recently as 1985, less than 25 per cent of all loans outstanding within the ECwere
not government guaranteed. By the end of 1993 this percentage had jumped to
over 55 per cent and over three-fifths of new lending 1990-93 carried no
government guarantees (Table 1).
Although the quality of guarantees required has been somewhat lowered, it
is still a firm benchmark of EIB lending practice to seek guarantees that are
virtually certain. Most other banks price loans to take account of default risk; that
is how they make profits even on a portfolio experiencing some non-negligible
percentage of loan-losses. Such behaviour is contrary to the philosophy adopted
by the EIB. Its lending-on rate has built in essentially no margin for loan-losses,
and its actual loan-loss experience to date has been altogether negligible. One of
the important functions of most financial intermediaries is evaluating and pricing

Table 1: EIB Reliance on Guarantees

Loans within the Community

1983 1988 1993

1. Percentage of outstanding loans
Governments 75.9 66.6 45.3
Public institutions 14.7 18.2 13.2
Financial institutions 3.5 7.2 25.2
Non-bank public enterprises 0.9 1.5 3.2
Mortgages (real estate) 0.5 0.5 0.5
Non-bank private 2.9 3.7 10.6
Other 1.6 2.2 1.9

1986-89 1990-93 1993

2. Percentage of new loans
Governments 54 38 33
Public institutions 20 11 9
Financial institutions 14 32 40
Non-bank public enterprises 2 4 0
Mortgages (real estate) 0 0 1
Non-bank private 7 13 10
Other 3 2 1

Source: Derived from EIB Annual Reports (some figures estimated by extrapolation).
2
Since financial institutions make a charge for providing guarantees, the total cost of servicing to the EIB
borrower is often higher than the interest charged by the EIB.
o Blackwell Publishers Ltd 1995
 THE PUBLIC POLICY ROLE OF THE EIB WITHIN THE EU 319
risk. Because it insists on what it regards as absolutely first-rate guarantees and
essentially no risk, the EIB has abdicated this function.
In order to fund its lending, the EIB has become one of the most important
issuers of straight long-term bonds with its issues approaching 5 per cent of the
world total in recent years. As a percentage of total 'foreign and international'
bond issues, the Bank's issues have also approached 5 per cent. The Bank's credit
rating is impeccable and the size of its issues makes for a high degree of liquidity
in the secondary markets.
The Bank's high credit rating can be attributed to four factors, in ascending
order of their importance to bond-holders: first, the quality of the project
selection, which has been sufficiently good to result in a very small rate of
recourse to guarantors; 3 second, the guarantees, from governments and other
sources, which back each loan; third, the paid-up capital and reserves; fourth, the
callable capital (which must be maintained above 40 per cent of loans outstand-
ing). Any one of these, with the possible exception of the first, would be enough
to copperfasten the high credit rating.
The Borrowers
The EIB has lent to a wide variety of borrower types, all across the EU, though
with a disproportionate representation of local and regional authorities and
public enterprises. An important element, accounting for as much as 30 per cent
of EIB lending recently, is the 'global loan' where the EIB lends to local financial
intermediaries 4 for lending-on mainly to small and medium-scale enterprises
(Pinder, 1986).
The reasons given by borrowers for choosing the EIB vary. Some borrowers
have used EIB funds because this allowed them to gain access to foreign currency
funds. A particular reason for favouring foreign exchange for some borrowers in
high interest rate countries was the fact that they were also able to avail
themselves of underpriced government exchange rate guarantees, thereby offer-
ing a lower overall cost of funds. Such exchange rate guarantee schemes have
been especially important in Italy, and probably contribute to explaining the
dominance of Italy in the EIB's portfolio for many years. Though curtailed, such
exchange rate guarantees still exist in parts of Italy and in Portugal.
Other borrowers find that the long maturity of EIB loans makes them
especially attractive. It is often costly, especially for a small borrower, to obtain
long-term funds even though the existence of interest rate swap markets makes
'Only a handful of loans have resulted in such recourse. In 1992 for the first time the Bank made a general
provision for banking risks, equivalent to 0.2 per cent of the net outstanding loan portfolio.
'The typical loan agreement with the intermediary governs, among others, the ceiling on individual loan size
(e.g.1Om ECU), the eligible regions and the type of project. The lending-on interest rate is usually governed
by local market conditions, though the BIB ensures that unreasonable margins are not imposed. The EIB
reserves the right to examine sub-borrower performance; but in practice this is done on a very limited scale,
especially after a relationship has been established with the intermediary.
o Blackwell Publishers Ltd 1995
320 PATRICK HONOHAN

it possible for local banks in most Community countries to provide long-term

funds. The improvements in the efficiency of financial markets still leave them
short of textbook perfection where funds of any maturity and in any size or
currency are always available. The EIB has generally been found ready to fill
gaps in the availability of long-term funds.
Some borrowers, especially in the more efficient financial markets, having
'shopped around', simply find BIB funds competitive on straight interest rate
grounds at the moment when they require the funding.
Finally, there are borrowers who find it attractive to have the EIB's seal of
approval on their project. It may be easier for a manager to sell the project to her
shareholders on the basis that BIB finance has been approved. It may very well
be that this kind of synergetic relationship between the Bank and its borrowers
also exists vis-a-vis potential guarantors. Thus a local or regional authority
whose infrastructural project is acceptable to the EIB may also find it easier to
obtain approval - and the necessary guarantee - from the state or a public
institution. It could be that in this way the EIB has had the effect of inducing
subsidized guarantees for its own borrowers.
Distributionby country. Table 2 presents the distribution of EIB lending in the
period in the last decade by country together with each country's share in EC
population and GDP. The table clearly demonstrates Italy's disproportionate
share of BIB funds ten years ago: well over two-fifths, compared with a share of
about 17-18 per cent in EC population and GDP. At that time, Denmark, Greece
and Ireland 5 were also disproportionate users of EIB funds, using the same
comparisons. At the other end of the scale Germany, with a larger population
than Italy, and more than one quarter of EC GDP, accounted for less than 2 per
cent of the stock in 1983.
Over the past decade the country composition of lending has changed
considerably, especially since 1989. Italy's use of EIB resources has declined to
the point where it is taking little more than its population share, whereas
Germany, though still well below population share, has become quite a signif-
icant user. Spain and Portugal have begun to access BIB funds in amounts which
are disproportionately large in comparison with population; Spain actually
overtook Italy as the biggest borrower for the first time in 1993. Ireland and
Denmark continue tobe relatively large users, though in Ireland's case to a much
less pronounced degree. Greece's share of recent lending is below its population
share.
Of course, the objectives of the BIB do not imply any proportionality in the
distribution of its lending across countries: rather the contrary. To the extent that
the regional difficulties and financing gaps are unevenly distributed, it is
5
Ireland was then the biggest outlier its heavy use of the BIB in the early 1980srelated to the interestsubsidies
made available to it by other Member States, but tied to borrowing from the EIB.
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 THE PUBLIC POLICY ROLE OF THE EIB WITHIN THE EU 321
Table 2: BIB: Distribution of Lending within the EU (%)
Loans
Stock Provided Provided Granted Population GDP
1983 1985-89 1990-93 1993 1993 1993

Belgium 2.8 0.5 1.7 2.1 2.9 3.3

Denmark 3.2 4.8 4.4 4.9 1.5 2.2
Germany 1.9 4.6 9.9 11.8 23.4 29.3
Greece 4.8 3.2 2.0 2.9 3.0 1.2
Spain 8.3 18.7 22.6 11.2 8.2
France 14.0 11.8 12.5 12.4 16.6 20.3
Ireland 9.0 2.4 1.9 2.2 1.0 0.7
Italy 42.5 41.3 24.5 19.0 16.6 16.8
Luxembourg 0.0 0.0 0.1 0.0 0.1 0.2
Netherlands 0.1 1.7 1.6 2.1 4.4 4.9
Portugal 4.3 7.6 8.4 2.7 1.3
United Kingdom 20.7 15.5 13.7 10.9 16.6 14.3

Total 100.0 100.0 100.0 100.0 100.0 100.0

Source: EJB AnnualReports and Information No. 79; Eurostat. 'Total' includes unallocable items.

reasonable to expect that some regions will receive greater emphasis than others.
Figure 1 shows a scatterplot of the stock of EIB lending in 1993 against GDP
(both per capita)which is suggestive of a negative relationship, with two outliers
- Denmark being on the high side and Greece on the low.
Among the various factors which are likely to have contributed to the actual
distribution across countries of EIB borrowing, most can be grouped under two
headings. Thus (a) countries with investment opportunities going beyond the
financing capacity of domestic savings (especially after taking account of
government dissavings), and (b) countries suffering inefficiencies or other
difficulties in the domestic financial system would be more likely to have
recourse to the EIB.6 Unfortunately, the data resist any simple quantitative
illustration of the relative magnitude of these factors.7
6The wide differences between EU countries in the efficiency and competitiveness of the banking systems
in Europe have been documented in recent studies, e.g. Price Waterhouse (1988), Neven (1990). Drawing
on a variety of indicators, Neven asserts that Germany, Netherlands and possibly the UK have the most
competitive banking systems. In Belgium, France and the Netherlands, competition has resulted in relatively
low bank profits, but prices of bank services may be less keen because of higher labour costs. At the other
extreme, Spain and Italy have highly profitable banking systems, with high labour costs: these presumably
provide the highest cost banking. 'The same can be said, to a lesser extent, for Denmark and, though it is not
covered by Neven, for Ireland. In addition, though this too does not emerge so clearly from Neven's data,
the banking systems of Greece and Portugal have been widely regarded as costly and inefficient.
'For each possible indicator, at least one country's level of EIB borrowing is quite out of line. For example,
a Blackwell Publishers Ltd 1995
322 PATRICK HONOHAN

DK

al

o 1-GR *'RL
0

UK 9F
DNL

0.4 0.6 0.8 1 1.2 1.4

GDP per head, EU = 1

Figure 1: EIB lending per head and GDP per head, 1993

Distributionby objective. In what may appear to be an exercise of public policy,

the EIB insists that any project receiving financial assistance from the Bank must
meet at least one of six objectives. This positive list, together with the volume of
associated lending in 1993 may be summarized as follows:

regional development (12.5bn ECU in 1993);

transport and telecommunications infrastructure (5.8bn ECU);
protection of the environment, etc. (4.4bn ECU);
energy (2.8ba ECU);
small and medium-sized enterprises (SMEs) (ECU 1.5bn ECU); and
international competitiveness of industry and its integration on a Com-
munity basis (1.2bn ECU).

With such a wide range of rather general objectives it is not surprising that some
lending is categorized under more than one heading (the total of the sums listed
above is more than half as much again as the total of lending in 1993).
The list of objectives is clearly comprehensive. Indeed, it would be hard to
imagine a project that could not be squeezed into one or other of these categories
as stated. Furthermore, borrowers report that the Bank adopts a flexible approach
in determining whether a project can be accepted as falling into the categories.

though high government deficits in Italy, Ireland and Portugal could help explain the high intensity of their
borrowing from the EIB in the 1980s, an equally high deficit in Belgium did not have the same effect. Much
the same ambiguity arises with nominal interest rates (cf. Honohau, 1992). A multiple regression approach
is also unable to quantify a stable relationship. Other variables, such as the size of the public sector, could
also be important.
o Blackwell Publishers Ltd 1995
 THE PUBLIC POLICY ROLE OF THE EIB WITHIN THE EU 323
For instance, many people are surprised to learn that EIB finances the purchase
of long-range passenger aircraft: but this obviously falls under the category of
transport infrastructure. It must be concluded that these positive objectives do
not provide a very selective or focused target for the EIB's lending activities.
The Bank does also have a short 'negative list' of areas where it either will
not lend, or is unlikely to lend, for reasons of Community policy. Even this
negative list can and has been challenged in certain respects, as in regard to the
reluctance to lend in support of R&D.
The list of objectives cannot help to explain in detail how the present pattern
of lending has come about. Virtually any bankable project not specifically on the
negative list could have been accommodated within the broad criteria chosen. A
more realistic way ofexplaining the present pattern of lending is to recognize that
the Bank's client base has been built up over the years and that its present sectoral
distribution is more a function of the Bank's response to opportunities as they
arose (and probably also of historical accident) than the result of a consistent and
explicit targeted sectoral approach.

The EIB's Mission

What does the EIB do that other large banks do not do? A reading of the stated
mission of the Bank8 is not very informative on this point. The Treaty calls for
the EIB to make loans on a not-for-profit basis for projects promoting regional
development, adaptation to the common market and projects ofcommon interest
to several Member States which by their size or nature cannot be fully covered
by existing financial institutions.9
In public documents and internal reporting, the EIB presents a wide range of
evidence concerning its contribution to the Community. Typically this involves
a sectoral classification as already discussed above. But the contribution of the
EIB to Community interest is not to be measured simply by a list of the sectors
receiving loans orby adherence to a negative list ruling out lending that conflicts
with Community policy. After all, the lending of most private banks could be
(and indeed often is) presented in much the same manner.
When the EIB was established over 30 years ago, the scope of banking was
quite restricted, national capital markets were much less developed and interna-
tional capital flows an order of magnitude smaller than they are today. Projects
of a size that could not be financed in the absence of the EfBf are now rare.10
While it would be a gross oversimplification to state that the market imperfec-
'This is now set out in Article 198c of the Treaty on European Union and, despite revisions, has not really
changed much over the years.
'It is now specifically required to facilitate the financing of investment programmes in conjunction with the
Structural Funds.
"eMherole of the EIB in helping finance the Channel Tunnel is given as an illustration of its public policy role
in this area.
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324 PATRICK HONOHAN

tions which led the founding fathers to create the EIB have disappeared, it is
certainly true that they have been very much reduced. As a result, when a large
and profitable commercial entity borrows from the EIB, both parties enter into
the contract with the awareness that alternative lenders exist. The interest rates
and terms of the loan are typically comparable to what would be offered by the
alternative lender; the borrower's choice of the EIB being made on the basis
either of some slight cost saving, or the interest of maintaining a relationship with
more than one source of long-term credit, or some such second-order consider-
ation. Smaller borrowers usually receive EIB loans from an intermediary for
whom the availability of EIB funds (through a global loan) is again a matter of
second-order convenience.
This general presumption of a fairly effective financial market environment
does not extend to all parts of the EU. Price differentials in banking can be an
important reason for the EIB to bring its resources to bear on less well-served
financial markets. By lending where the local banking system is a high cost one,
the Bank can contribute to economic cohesion. Not only does it lower the cost
of funds to the final borrower, but the competition should also stimulate the
domestic banking system to respond with improved efficiency.' 1
Aside from the handful of very large-scale projects, it is hard to identify a
public policy and cohesion-promoting role of the EIB (within the EU) other than
its readiness to fund sound projects at competitive prices where the local
financial market displays inefficiency. Without such a role one would begin to
wonder whether the EIB should be privatized.
Even this role may be expected to shrink inexorably. Continued development
in the sophistication of domestic capital markets will allow more and more first-
rate borrowers direct access to capital markets, making it unnecessary for them
to resort to banks, including the EIB. Cross-border competition in banking has
been negligible to date, but can be expected to strengthen. Experience in
Australia and Canada where entry to the banking system has been liberalized in
recent years shows that, even if foreign banks do not dramatically increase their
market share, the threat of foreign competition will induce a response by the
domestic bankers in the direction of improved efficiency and lower margins.
Domestic banks will become more attuned to local borrower needs for long-term
capital and they will be able to provide strong competition for the EIB.
These improvements in banking efficiency across Europe, spearheaded by
the completion of the internal market in financial services and (if the single
currency becomes a reality) the elimination of exchange risk, could ultimately
result in a situation where the public policy functions of the EIB were no longer
relevant.

"A detailed micro-based analysis by Faini etaL (1993) provides interesting evidence of price differences,
which they attribute to monopoly rents in southern Italian banking.
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 THE PUBLIC POLICY ROLE OF THE EIB WITHIN THE EU 325
M. New Directions
Looking to the future, it is clear that the EIB will not have things all its own way.
Many of the niches in which it has prospered (both geographically and in terms
of products) have attracted new competitors. Rapid balance sheet growth is
unlikely to be sustained indefinitely. Nevertheless, the tight control that the Bank
has kept over administrative costs should enable it to survive in the market place.
Its comparative advantage remains in the supply of funds, and thus it may find
itself moving more and more into a wholesale role. But such issues have little to
do with its public policy role, which is our focus here.
Given the present relatively limited and shrinking public policy role which we
have identified above for the EIB, it is reasonable to ask: what else could the Bank
do that it is not doing now? Are there ways of building on the strengths of the
institution to perform a public policy function not hitherto attempted? There
have already been some new initiatives in this area. The provision of risk capital
and loan guarantees seems likely to form a growing part of the EIB's remit in the
future, and its continued use as administrator of explicit interest subsidies means
that these too will remain an important part of its activities (although they will
not draw on the Bank's own resources).
In contrast to straight long-term lending on a well-secured basis, the provision
of risk capital and loan guarantees requires considerable sophistication in the
evaluation and pricing of risk. Incorrect pricing of risky financial contracts
involves an implicit subsidy, and experience shows that errors in this area can be
very costly.
Because many aspects of EU policy involve subsidies, their emergence and
growth in the financial sector may not seem out of place. But it is very difficult
to design successful subsidy schemes, whether implicit or explicit, for the
financial sector. The problem is that the key role of banks and other financial
institutions (as identified by recent literature1 2) in the modem economy is to
choose, on the basis of imperfect information, which borrowers should receive
loanable funds. The difficulty of assessing creditworthiness probably results in
2
Among the many examples of different strands in this literature we may mention the following. Gertler
(1988) provides an excellent introduction to the literature and shows how the presumption of underinvest-
ment arises. However, de Meza and Webb (1990) show how a small modification to a standard model can
reverse the policy prescription, thereby revealing how sensitive and complex the policy issues can be. Hoshi
et aL (1991) demonstrate the empirical relevance of a good banking relationship for ensuring enterprises'
access tocredit. Greenwald etal.(1993) explicitly examine the theory of regional creditpolicy interventions,
and discuss the possibility that a region's ability to recover from a negative shock may be hampered by
impairment of the regional banks' balance sheet. These papers all stress a variety of principal-agent
problems, where banks cannot wholly rely on their borrowers and where potential depositors cannot wholly
rely on banks to remain solvent. Attempts by principals to protect themselves by insisting on higher interest
rates can worsen the overall outcome, and there are many models in which an omniscient policy-maker can
improve things by subsidizing 'good' financial market activities. But in reality the policy-maker is also faced
with principal-agent problems in dealing with the banks, and cannot be sure that the subsidy will reach its
target.
O Blackwell Publishers Lid 1995
326 PATRICK HONOHAN

some lending to the wrong people, in excessive reliance on collateral (so that
would-be borrowers who have no collateral to offer may lose out), and possibly
in underinvestment overall. While such market imperfections may call for public
policy intervention, the same information problems and the fungibility of money
make subversion of subsidies likely (cf. Akerlof and Romer, 1993). Indeed,
majority opinion has shifted away from the use of the financial system for
subsidization (cf. World Bank, 1989).13 When one adds the fact that many
financial sector subsidies are hidden ones, so that their scale is not generally
known, it is clear that some caution needs to be applied.
Admittedly, the entry of as professionally managed an institution as the EIB
into such areas as risk capital and loan guarantees need not involve systematic
pricing errors or unintended subsidies. But if that is how it is to proceed, one may
conclude that in these fields too it will soon become no different to private
intermediaries whose analogous activities throughout most of the EU are
increasingly effective.

Risk Evaluationand Pricing

The extremely conservative banking stance adopted by the EIB has to date
resulted in its accepting practically no risk for the account of its shareholders or
bondholders. Accordingly, though not all of the projects financed by the Bank
are risk-free, the financial risks involved have been assumed by others, notably
the guarantors. Recently the Bank has been preparing to accept more risk, and
thereby to contribute to the amount of risk capital available in the Community.
Specifically, the EIB's statute is being amended to permit it to manage a new
European Investment Fund. This fund will be endowed with a capital of2 billion
ECU (of which 40 per cent will be provided by the EIB itself) 14 and it will
guarantee financing for infrastructure connected with trans-European networks
and SME investment. Later on it may undertake equity investments.
A more active approach to risk requires new products and new pricing
methods. We may distinguish between loan-type and equity-type finance. With
the latter, the banker will not share significantly in the high profits of a successful
project. Accordingly she needs to charge a sufficiently high interest rate to allow,
firstly, for the losses incurred on unsuccessful projects which were unable to
repay borrowed moneys and, secondly, for the additional staff resources which

OThe interest subsidy often fails to find its target: if channelled through private banks, the benefit goes to
their best eligible customers (and indeed some may stick with the bank); if channelled through a public
agency, it tends to attract a disproportionate number of no-hope projects which have already been screened
out by the banks. There are more subtle problems, including the adverse psychological effect subsidies can
have on financial discipline, including a tendency for borrowers to anticipate special tolerance towards
repayment difficulties.
"It is envisaged that the EU will subscribe 30 per cent and 'public and private banks' the remaining 30 per
cent.
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 THE PUBLIC POLICY ROLE OF THE EIB WITHIN THE EU 327
need to be deployed in risk evaluation. But interest rates cannot be set too high:
otherwise too many prudent promoters will be discouraged, leaving the banker,
at the limit, having a client base of reckless or dishonest borrowers. The banker
must find a middle path: she will pitch the interest rate on risky loans somewhat
higher than that for secure loans, but in addition she will take steps to refuse the
riskiest type of borrower.15 Much the same consideration applies to loan
guarantees: if she is to break even, the banker must price these too on the basis
that they will yield enough to cover for calls on the guarantee and to pay for the
costs of evaluation. The guarantees of the European Investment Fund are to be
priced in order to provide the Fund's capital with a market rate of return.
Pricing in the case of equity amounts to a decision as to what share of the
enterprise will be taken in return for the sum invested. By pooling equity
investments in a number of risky projects, a risk capital fund can become an
acceptable investment even for a cautious bank; after all, the capital gains from
successful equity investments made by the fund can offset the losses from the
failures. The managers of the risk capital fund will typically become involved in
oversight of the strategic management and performance of the projects to a
greater extent than is possible for the banker who merely provides a loan. One
reason for this additional monitoring of the progress of the enterprise is the need
to ensure that the resources of the enterprise are not subverted and do actually go
to the benefit of all the shareholders. However, this monitoring is costly in terms
of staff resources, and uses skills that have not hitherto been a major part of the
EIB's toolkit.1 6
The move to widen the public policy role of the EIB by expanding its
provision of risk finance (at first through guarantees and later perhaps with
equity) sets out to be based on a no-subsidy doctrine. Is this reasonable, or could
there be a case for at least some degree of implicit subsidy, bearing in mind that
the EIB already manages some subsidized lending?

Subsidies:Implicit andExplicit
Explicit interestsubsidies managedfor others. Although constrained by statute
not to provide interest subsidies itself, the EIB has acted as a conduit for interest
subsidies provided by others and attributable to loans made by the EIB. The
largest case was the granting of subsidies to Ireland and Italy at the time of their
accession to the European Monetary System which began in 1979. Those
subsidies were attached to EIB lending. After many years without new subsi-

"This point was stressed by Stiglitz and Weiss (1981). Black and de Meza (1992) illustrate the use of high
collateral requirements as an alternative to higher interest rates to discourage wilful default.
"A simple comparison of the size of the EIB's staff, at fewer than 800, with that of the World Bank, at more
than 6,000- for an equivalent volume of lending - provides an indication of the modest degree to which the
EIB is at present geared for the hands-on role of 'development banking'.
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328 PATRICK HONOHAN

dized lending, two new waves of interest subsidies for EIB lending have recently
been announced. One is funded from the EFTA countries in the context of the
EEA arrangement, and came into effect in 1994. It will benefit Greece, the island
of Ireland, Portugal and the disadvantaged areas of Spain. It is envisaged that
interest subsidies of 2 percentage points per annum will be provided on ten-year
loans totalling 1.5 bn ECU. The other wave is an initiative of the Council of
Ministers and involves 1 bn ECU of loans to SMEs. These will carry interest
subsidies of 2 percentage points per annum. As with previous subsidy schemes,
these interest subsidies have not been funded by cross-subsidization from other
borrowers, or out of the capital resources of the institutions, but from budgetary
subventions.17
The total subsidy envisaged by the two new interest subsidy initiatives
amounts to 50 million ECU per annum - not a huge distortion in the overall
financial system. Indeed, such a sum is equivalent to only one week's worth of
the EIB's profits. So it would be wrong to overstate the likely scale of the
distortion that is involved or of the benefits which might be obtained.
Possibleimplicit subsidiesfromunderpricedloan guarantees.Publicly provid-
ed loan guarantee schemes are often implicitly subsidized through under-
pricing. Those proposed for the European Investment Fund are to be made at
break-even rates. While achieving such pricing should be technically feasible, it
is well to be aware of the tendency for unintended implicit subsidies to creep in.
To the extent that the lending institution is insulated from the consequences of
loan delinquency, its screening of potential borrowers is likely to be more
cursory. Therefore, unless the guarantor carries out an effective credit screening
the guarantee programme will tend to accept a disproportionate number of
uncreditworthy borrowers. If unanticipated, such an effect will result in worse-
than-allowed-for loan-loss experience and result in an ex-post implicit subsidy.
Although good contract design can in principle mitigate such problems, experi-
ence shows how easy it is to fall into this trap. 18
Subsidizingventure capital?Could the subsidization of venture capital activities
be an exception to the general presumption against financial sector subsidies?
One reason for the comparatively small scale of such activities in Europe is the
high set-up costs of a venture capital project, costs that are largely independent
of the scale of the borrowing. The disproportionately small size of firms in the
EU periphery probably justifies some subsidization here in line with the other
extensive forms ofsubsidy to enterprises which now prevail under the Structural
"By giving the ElBaprivileged position, interest subsidies selectively granted toborrowingmade by it might
weaken its role in promoting improved financial sector efficiency through fair competition.
**Gale (1991) documents the significant welfare costs generated by a variety of loan guarantee schemes in
the United States. He does not include the huge costs of deposit insurance - which was effectively a greatly
underpriced guarantee scheme for loans to (deposits with) financial institutions.
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 THE PUBLIC POLICY ROLE OF THE EIB WITHIN THE EU 329

Funds regime. To the extent that the equity contract involved in venture capital
ensures that, despite subsidization, the incentive for evaluation and monitoring
is substantially intact, well-designed subsidization of the equity investments
made by venture capitalists is arguably less distorting than subsidization of
interest or the guaranteeing of loans. But it would seem preferable to design such
a subsidy scheme so that it could be open to a wide range of intermediaries,
whether public or private, rather than being channelled exclusively through the
BB. 19

IV. Conclusion
In contrast to the situation which prevailed when it was founded, the EIB is now
only one of a variety of alternative providers. This is clearly the case for large
borrowers, whether in the public sector or not, and is also true of most small
beneficiaries in that they access EIB funds only through intermediaries in the
'global loans'. Many of its borrowers have alternative possible sources of funds
at similar interest rates and even at similar maturities. As the efficiency of
financial markets in Member States improves, a process that will be accelerated
by the completion of the internal market and progress towards EMU, the role of
the EB in achieving Community objectives will tend to become less central. For
the immediate future, however, the EIB remains a force for promoting cohesion
through enhanced competition and efficiency in the lagging financial markets.
Despite the rapid development in financial markets in all Community
countries, there are still gaps and the exercise of monopoly power. By providing
long-term funds and competitive rates even in the less competitive markets, the
EIB promotes cohesion by maintaining a degree of pressure on private interme-
diaries. This pressure has, however, been confined to the segment of the market
relating to long-term guaranteed borrowing.
Recently the EIB has decided to move into the area of risk finance, with which
its ample reserves would be well able to cope. This will require careful evaluation
and pricing of credit risk, an area in which the Bank has not hitherto had to have
much experience. Because these new activities are to be on an unsubsidized
basis, it seems that they too will prove to have only a limited public policy role,
and that the EIB is intended to act much as private intermediaries do in these
fields. Nevertheless, because of the much greater scope for discretion in pricing
of risk finance, there is the danger that - perhaps in a misdirected attempt to
expand its public policy role - the Bank could be drawn into providing implicit
subsidies in its risk finance activities. The benefits of such subsidies would be
questionable.
"The proposed private participation in the equity of the new European Investment Fund suggests that no
shareholder subsidization of its activities is envisaged.
O Blackwell Publishers Ltd 1995
330 PATRICK HONOHAN

The search for a really distinctive public policy role for the EIB will no doubt
continue. But our review of the situation to date suggests that, as its financial and
administrative structure has evolved, the EIB's comparative advantage may not
be in providing a specifically public policy role within the EU.

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