Municipal financial advisors play an important, but often under-examined, role in how state and local governments access financial markets. In a recent study published in Public Budgeting & Finance titled, “The Evolving Role of 21st Century Municipal Financial Advisors,” Professor Daniel Garrett and his co-author Baridhi Malakar explore how this advisory landscape has evolved over the past twenty years, shaped by regulatory changes, shifting market dynamics, and growing demand for financial guidance.
What are the main functions of municipal financial advisors, and what motivated you to study the evolution of their role?
Daniel Garrett: It might be a bit on the nose to say that municipal financial advisors provide advice about finance to municipalities, but these advisors can provide advice about all sorts of borrowing or investing decisions for U.S. municipal entities. Most prominently, municipal financial advisors help guide state and local public entities through the process of issuing municipal bonds, which can have many complications including trying to structure the timing of when bonds will be paid back, whether to include extra features like bond insurance, and how to hire an investment bank who will underwrite the bond. Municipal financial advisors can also provide advice on other financial decisions a municipality might be making: Should we refund our existing bond or should we pay it off? How should we invest the cash that we currently have before we need to spend it? If there is a financial decision that a municipality needs to make, they might seek out the advice of a municipal financial advisor to try to make sense of the tradeoffs.
In this paper, we chose to study the evolution of this market for financial advice for two reasons. First, the financial market decisions of state and local public entities in the U.S. are both understudied for their relative economic importance and potentially influenced by a large number of underappreciated factors, of which financial advisors are one. Municipalities owe about $4.2 trillion to investors through municipal bonds and at least another $1.5 trillion in unfunded pension obligations to retired workers, so the borrowing and investing decisions of municipal entities may have large economic effects on many people. Second, my coauthor Baridhi Malakar and I both wrote portions of our dissertations about how the Dodd Frank Wall Street Reform Act of 2010 changed the operation of municipal financial advisors and how this led to changes in the costs that municipal entities paid to access financial markets. We both realized that there were interesting patterns in the narrower data we used in our dissertations and wanted to have the opportunity to explore those patterns over longer time horizons stretching back to 2000 and up through today.
How did regulation in the 21st Century reshape the municipal financial advisory industry?
Daniel Garrett: The biggest change to regulation of municipal financial advisors in the last 25 years came through the Dodd Frank Wall Street Reform Act of 2010 (Dodd Frank). This new law gave rulemaking authority regarding financial advisors with the purpose of protecting issuers to the regulator in the municipal bond space, the Municipal Securities Rulemaking Board (MSRB). The law also codified a fiduciary duty standard for all financial advisors, which used to be a “facts and circumstances” determination meaning that financial advisors were not required by law to sell advice that was in the best financial interest of the borrower.
This change in regulatory environment led to a number of developments in the next few years that we document more completely in the paper. Some of the highlights were:
- A new SEC/MSRB registration requirement for advisors.
- A new Series 50 exam for people providing financial advice to municipalities.
- New restrictions on political donations and general professional behavior of advisors, including social media.
Over these last 2.5 decades, municipal financial advice has moved from something that commonly existed but was only lightly regulated to an activity where all sorts of behavior is now defined and restricted.
Your paper documents a rise in the use of municipal financial advisors — from about half of bond deals in 2000 to more than 80% today. What stands out to you about this trend, and what does your analysis suggest about how advisor usage has evolved across the market?
Daniel Garrett: As you note, there has been a striking increase in the use of municipal financial advisors in the process of taking bonds to market. One of our first questions was why this has happened, and our first guess was that this reflected a change in the types of borrowing that municipalities needed, moving toward more financing structures that could benefit from advice. We test whether this is the case using a statistical mean decomposition sometimes called a Kitagawa-Oaxaca-Blinder decomposition, which separates the use of financial advisors in each year into three components relative to the year 2000: (1) changes in the composition of borrowing, (2) changes in how observable characteristics relate to the likelihood of using an advisor, and (3) and unobserved component. While I thought that (1) was likely to be most important when we started, we actually found that the increase in advisor usage is not related to the fundamentals of projects at all. Instead, the increase fell under category (3), which means that advisor use is increasing broadly across all types of projects and types of borrowing.
The fact that this increase in municipal financial advisor usage in the municipal bond issuance process is broad does not tell us specifically why the usage is increasing, although it does rule out stories that are related to certain parts of the market or certain services that advisors are providing. This is not just that bond contracts or the process of issuing a bond is becoming more complicated or something like that. Hopefully the next paper will have a more definitive answer about the sources of this increase in the use of municipal financial advisors!
At the same time, you show the number of operating advisors has declined. What patterns do you observe in which firms are exiting, and what are the potential explanations for this shift?
Daniel Garrett: There are three major ways that a firm may exit from the market: (1) firm closure, (2) firm reorganization, and (3) consolidation with other firms.
I think some market participants and observers are particularly worried about closure and reorganization being potential outcomes due to a new and maybe more onerous regulatory environment. If the new regulations make providing advice too costly through making exams that are too challenging or restrictions on professional behavior that scare away good employees, firms may close down because it simply isn’t profitable. Other firms may reorganize to focus on related but less regulated activities that could be more profitable and are still less regulated than financial advice is now. Closure or reorganization away from providing advisory services could lead to less availability of advice when needed and maybe less competition among advisors.
The other option, consolidation, is what we find the most evidence for in a small sample of the largest observed withdrawals of SEC registrations for advisors in the last decade. Of the five largest withdrawals, one is a name change, one is more akin to a reorganization, and three are related to mergers and acquisitions. M&A can happen for many reasons and be welfare enhancing or detracting for clients. There is scope for more studies of any consolidation in the space and what the implications are for borrowers.
What are the biggest unanswered questions about municipal financial advisors that future research can explore?
Daniel Garrett: In the paper, we relate the presence of financial advisors over time to other phenomena that have been important in the last few years: (1) structural complexity of bonds, (2) textual complexity of disclosures, and (3) the timing of early refunding decisions. The idea of each of these analyses is to document where municipal advisor presence appears related or not related to other phenomena that may be important in the market.
To our surprise, we found that advisors are more likely to be present in bonds that are less complex, both in structure and in the language used to describe the bonds in official statement filings with the MSRB. My initial thought was that municipal borrowers with complicated situations that need various bells and whistles in the bond structure or require more complex information to describe would be more likely to hire advisors, but this is not the case. Since both sources of complexity are reasons why borrowers often have to pay extra to access capital markets, there is lots of scope for future research to understand whether advice is being underutilized and how the presence of advisors interacts with complexity and why.
We also show that bonds with advisors are more likely to be rolled over earlier. Many municipal bonds have call options that allow borrowers to pay back investors early and re-issue bonds at lower interest rates after a certain date. We find that borrowers who hired advisors at the time of issuance are more likely to exercise these call options around the dates such transactions become possible. This pattern of earlier and more prompt calls combined with the very high persistence of relationships with advisors over time suggests advisors could matter a lot for long run fiscal outcomes of borrowers. How does the advisory business promote long term fiscal sustainability in borrowing and investing for public entities? I think there is heterogeneity in advisor quality as well, and another potential line of inquiry is learning how the best advisors provide different advice over the long run.
Read the paper, “The Evolving Role of 21st Century Municipal Financial Advisors” on Public Budgeting & Finance.
Learn more about Professor Daniel Garrett.
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