Public investment banks could be a powerful tool for growth

If they are well structured and governed, public investment banks can be powerful catalysts for investment-led growth. But governments that establish such institutions should adhere to four guidelines.

The global financial crisis showed that plentiful finance can generate growth that is not necessarily sustainable or socially useful. Since then, the assets of the global banking sector have increased by some $40 trillion, and yet there is still not enough sustainable growth. Why?

The short answer is that finance is not “neutral.” There is a big difference between financing investment in the real economy and speculative finance that prioritizes short-term capital gains from trading existing assets. We need more of the former, and less of the latter.

With countries around the world facing major challenges, from climate change to aging populations, we urgently need new ways to finance smart, inclusive, and sustainable investment. Well-designed public investment banks are one such solution.

Investing in new and innovative areas is risky, and the private sector will often not commit until future returns become more certain. As a result, public institutions have traditionally played an important role in providing patient, long-term finance. From technological breakthroughs such as the Internet to environmental challenges such as the fight against climate change, public financing has enabled some of our greatest endeavors.

In many countries, patient finance increasingly comes from public investment banks. These can be national institutions, like Germany’s KfW, or multilateral ones such as the European Investment Bank. Because these banks are typically not under pressure to deliver short-term returns, they can provide longer-term financing, place a higher priority on broader social and environmental objectives, and take a different approach to risk and reward than private-sector institutions.

Until recently, public investment banks focused mainly on infrastructure investment and counter-cyclical lending. But many have now taken on more active “mission-oriented” roles to confront the key social and environmental challenges of the twenty-first century.

In recent years, governments in Europe, Asia, Africa, and Latin America have established several new public investment banks. One of the most interesting initiatives is in Scotland, where in 2017 First Minister Nicola Sturgeon announced plans to establish a “mission-driven” Scottish National Investment Bank. Scotland is already a global leader in the transition to a low-carbon economy and in promoting inclusive growth, and the government has recognized the need for new investment to help it achieve these goals.

Not all public investment banks are successful, so understanding what works and what does not is vital. Over the past 18 months, we have assisted the Scottish government in the design and implementation of the new bank, drawing on path-breaking research by the UCL Institute for Innovation and Public Purpose.

Our work has examined how the design of public investment banks influences their role and impact. From this, we identified four lessons for structuring such banks most effectively.

For starters, the bank’s mandate is crucial. Whereas some public investment banks have a narrow remit to support particular sectors, customers, or activities, many of the more successful ones have broader mandates that enable them to support a wider range of economic objectives and respond to emerging priorities. Moreover, such banks tend to be more effective when they finance specific “missions” aligned with government policy. Banks that promote directionless economic objectives such as growth or competitiveness, on the other hand, often end up supporting incumbent firms to carry on with business as usual.

Second, public investment banks need new monitoring and evaluation frameworks that adequately capture the dynamic spillovers generated by bold, catalytic investments. This should help to reduce the (occasionally merited) criticism of these banks for “picking winners” and “crowding out” business. Rather than focusing on “fixing” market failures, these frameworks should instead measure the success of public investment banks in catalyzing new activity that otherwise would not have happened.

Third, employees in public investment banks generally have broader collective expertise and capacities than those in private financial institutions. As well as financial know-how, staff have significant engineering and scientific knowledge. As a result, such banks can base their investment decisions on a wider set of criteria than market signals alone, and are better placed to appraise social and environmental factors.

Effective governance is the final key component. Many of the problems commonly associated with public banks, such as financial mismanagement and interest-group capture, have resulted from poor governance. To avoid this, these banks need to find the right balance between political representation and independent decision-making. While public investment banks must be democratically accountable, and ideally should finance projects in coordination with government policies, their management teams should be free to make sound, long-term decisions in line with the bank’s mandate, free of day-to-day political interference

If correctly structured and governed, public investment banks can be powerful catalysts for investment-led growth. By deciding to establish such a bank, Scotland has taken an important step toward achieving its bold ambition to become a dynamic, inclusive, and low-carbon economy. Other countries should watch closely and take note.