General fund reserves are one of local governments' primary resources for responding to unexpected financial losses, such as those brought about by natural disasters or man-made extreme events. However, it is neither practical nor desirable for a government to accumulate enough reserves to respond to every possible contingency it might face--that would simply not be affordable for most communities. Therefore, governments should consider other having financial risk management tools at their disposal, beyond reserves (e.g., insurance). One such instrument is internal borrowing.
Many, or perhaps most, local governments divide their financial resources into various funds. Fund accounting has its advantages, including a better ability to isolate the assets needed to achieve a particular public purpose. But this isolation also works against optimal risk management. Just as a larger insurance pool will usually be better off than a smaller pool, a government will be better able to respond to risk if it can bring all of its resources to bear.
A strong internal borrowing policy can deal with risk by providing many of the benefits of pooling financial resources while avoiding the problems of comingling monies that fund accounting is intended to solve.
Internal borrowing should be considered if a government finds itself confronted with an emergency that exhausts its reserves. The government will need to access money from somewhere, but there may be better options than internal loans in this kind of extreme circumstance.
Ideally, the Federal Emergency Management Agency (FEMA) or state resources would fill the gap. However, the number of disasters has been increasing (see Exhibit 1) much faster than the rate of population growth. Research also shows a trend of significantly increasing aggregate financial losses from disasters. (1) As a result, one might question whether FEMA or state governments will have the financial wherewithal to keep pace. In fact, many local government finance officers have already experienced long delays between when a disaster occurs and when financial support from FEMA arrives.
If FEMA assistance may not be as reliable as it once was, perhaps private markets could provide a source of capital.
Unfortunately, accessing private capital in the aftermath of a disaster presents problems: * External lenders may be wary of a government's ability to repay, especially if the disaster impaired the tax base.
* The borrowing would take place under harrowing circumstances, compromising the government's ability to negotiate optimal terms.
* Many forms of external borrowing require satisfying extensive legal requirements, but time is usually of the essence...