Larry Summers

10/13/2015

During the annual IMF-World Bank meetings last week in Lima, Peru, I was part of a discussion on a proposed pandemic emergency financing facility. The subject brought together two things I am very interested in. First, The Lancet Commission on Global Health 2035, which I recently chaired, argues that under-investment in health-related global public goods is a major problem–and that in particular the world is badly under-investing in epidemic and pandemic protection relative to the risks involved. Second, after all that has gone wrong in recent years, it seems incumbent on all of us involved in finance to think about how financial innovations can address the real problems of real people.

The idea under discussion is a potentially powerful one: some public entity would issue bonds to investors which would be deemed to default in the event of an epidemic, assuring the availability of resources to respond before the epidemic takes on pandemic proportions. The facility would complement the new WHO contingency fund as well as its existing financing mechanisms. Such bonds are routinely issued to mobilize resources that will trigger in the event of hurricanes or earthquakes. So called catastrophe bonds or cat-bonds offer higher yields to investors in return for taking risks that are not correlated with the normal risks of business cycle downturns.

This has the potential to be a win-win-win. The World Bank is using financial innovation to mitigate a major threat to the world, and especially the world’s poor. The vast resources of the global capital market are being tapped to provide vitally important insurance – and bring much-needed financial discipline to pandemic preparedness and response. And investors who, at this time of zero rates, are desperate for return are getting a new vehicle in which to invest. Little wonder that the session brought together health advocates, national aid agencies and leading financial firms, all of whom were very positive.

I hope 2016 will see the advent of epidemic or pandemic bonds. But there are two hurdles that will have to be overcome if this initiative is to succeed. These hurdles, amidst the happy talk of cooperation, were I thought somewhat elided in the conversation.

First, a suitable price has to be found for these bonds: a price that works for both investors and for those who will issue them. Experience with hurricane and earthquake bonds suggests that in order to accept a 1 percent chance of default, investors require about a 3 percent yield premium. The same is likely true of epidemic or pandemic bonds. In an expected value sense the bonds are expensive for issuers and attractive to investors. So the question posed is this: As an aid agency concerned with, say, health in sub-Saharan Africa, is it better to pay $3 million to support the issuance of a bond that will with 1 percent probability pay off $100 million or is it better to give the $3 million to support improvements in local health care systems?

Second, a suitable contract has to be drafted specifying when exactly the bonds will default. Investors will expect something observable that does not involve any discretion so that actuaries can make rigorous models. The health community seems to see these bonds as vehicles for driving all sorts of good things like reform of local systems and very rapid response at the first instant in an epidemic situation. A way of satisfying both constituencies needs to be found.

I think these problems are solvable. But it will take more than rhetoric of cooperation and good will. It will take good ideas and hard negotiation. We can all hope that they will be forthcoming.