Capital innovation will take MDBs some way, but not all
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Capital innovation will take MDBs some way, but not all

55th ADB Annual Meeting (2nd Stage): ADB Board Governors visit to Malolos-Clark railway project site

The next 10 years will be a period of intense change for multilateral development banks. The demands on them, already high, are set to multiply as climate change worsens. The system as it is cannot bear much more load. Reform is coming. As Jon Hay reports, it will be difficult, but could unleash great innovation and a more co-operative, efficient sector.

Whatever the question facing policymakers — the war in Ukraine, food insecurity, climate change, biodiversity — multilateral development banks are declared to be part of the answer. The worse the world’s problems grow, the bigger the workload governments shove towards them.

And yet despite hurricanes, pandemics and interest rate shocks, the MDBs’ role in the world economy has remained strangely static. Their loan books have grown, but they have been far outstripped by the ballooning of private bond and loan financing to emerging markets.

Of course, it would be worrying if private capital markets didn’t outgrow the MDBs. The more they can take over financing development, the better.

But private debt markets are an unreliable partner. Their growth has tailed off in the past 10 years, and in 2022 the stock of EM bonds actually contracted for the first time, by $420bn or 3%.

More seriously, private debt goes overwhelmingly to the haves in the developing world, not to the have-nots.

The UN’s report in July on progress toward the Sustainable Development Goals found Covid had erased more than four years of progress against poverty. About one in 10 people worldwide suffers from hunger and a third lack regular access to adequate food — and that was before the Ukraine war disrupted countries that supply 30% of the world’s wheat.

Market forces have clearly failed to eradicate these and many other social evils.

No wonder Sri Mulyani Indrawati, Indonesia’s minister of finance, said when reporting the conclusions of the G20 finance ministers’ meeting in Washington in October: “We are going to ask the MDBs to use their resources and capacity to respond to the needs of many emerging markets and developing countries.”

Powerful numbers

In the same speech, she mentioned a subject that has been on the lips of officials from all over the world in the past few months, yet before that was unknown to all but a tiny handful of experts — the MDBs’ capital adequacy frameworks.

These obscure mathematical constructs, barely understood even by most MDB employees, govern how much lending they can do and how much risk they can take, based on their capital resources.


They are at the very heart of the MDBs and their ability to support development, but for a complex set of reasons have been almost entirely ignored.

The secret no one has wanted — or been equipped — to talk about is that MDBs could lend far more than they do with the capital they have. Up to $1tr more, even without being downgraded, S&P estimated in 2016.

The biggest issue is callable capital. Most of the capital provided by the MDBs’ shareholders — national governments — is not paid in, but can be called if needed.

Although this is legally capital, and the major rating agencies give considerable credit for it, most of the MDBs have played super-safe and constructed their capital adequacy frameworks as if this capital did not exist. As a result, their safe leverage limits are applied to a smaller base of capital than they need be.

Since its foundation, the World Bank’s main unit, the International Bank for Reconstruction and Development, has only ever been given $20.5bn of paid-in capital. Shareholders have granted it $307bn of total subscribed capital, but the bank does not get as much benefit from that as it would if it were paid in. There is a theoretical risk that if an MDB ever called for this capital — none ever has — one or more of the shareholders might be unwilling or unable to honour its commitment.

The IBRD’s paid-in money has gradually been augmented from retained profits to $50.5bn of usable equity.

Based on that alone, in S&P’s analysis, it has a standalone rating of aaa, before any ‘extraordinary shareholder support’, which includes using callable capital, is factored in.

Standard & Poor’s is willing to give credit for the 15% of IBRD’s callable capital, or $41bn, that comes from its 10 triple-A rated shareholders. The IBRD’s standalone rating of aaa could fall by two rating notches — through, for example, doing more or riskier lending — and the bank would keep its AAA rating.

However, the IBRD does not use that leeway, instead keeping its standalone rating aaa. What is on the back of an envelope an 80% potential increase in lending lies idle.

The long omerta about this issue was broken in July, when a panel of 14 experts commissioned by the G20 to look into capital adequacy frameworks produced a report, Boosting MDBs’ Investing Capacity. It contained an action plan of five recommendations.

The MDBs and their shareholders should change how they define the banks’ tolerance for risk. They should give more credit to callable capital. MDBs should expand their use of financial innovation to create more capital or shift loan risk. They should give the rating agencies more clarity on governments’ support for MDBs, to encourage the agencies to trust this more. And they should publish more data and analysis on MDBs’ finances, to enhance trust and decision-making by MDBs and the private sector.

If these recommendations were implemented, it could lead to a substantial increase in the MDBs’ balance sheets, and hence senior bond issuance; a flourishing of new instruments for shifting risk between institutions, including to the private sector; and a long overdue expansion of private sector co-investment in development finance.

Stuck in the long grass

There have been panels and reports before whose worthy conclusions have stayed on the bookshelf.

In 2015, the G20 under Canada’s presidency produced a five point MDBs Action Plan to Optimise Balance Sheets, which recommended operating with higher leverage and sharing risk with private investors.

But the report failed to ignite reform. “Frankly, the MDBs pushed back a lot,” says Tim Turner, the African Development Bank’s chief risk officer at the time.


The G20 asked the MDBs to respond. The World Bank led the process. “We asked: ‘What do you want us to do?’,” says Betsy Nelson, who was then chief risk officer at the European Bank for Reconstruction and Development. “We are not capital-constrained, so why should we spend a lot of money developing and executing new tools we currently do not need?’”

In Nelson’s view, “A mistake the G20 made was that they communicated to us [MDB chief risk officers], but not to their board members. The G20 was saying ‘lend more, take more risk’. But some G20 board members were saying ‘no, we’re happy, don’t do it’.”

Even though the G20 members are shareholders in most of the MDBs, they did not use their influence on the MDB boards to support the policy ideas they had proposed at the G20.

“And there were non-G20 board members who believed the G20 should not tell them what to do,” Nelson adds.

Even with such a powerful backer as the G20, an effort to invigorate the MDBs was stymied by entrenched problems in MDB governance.

Better chance

The signs are that this time will be different. The G20 has done its work more thoroughly, commissioning an independent panel with diverse perspectives, which could research and debate the issues thoroughly and consult most of the important stakeholders before publication.

Although the MDBs themselves, particularly the World Bank, were initially extremely wary of the report’s arguments, several influential governments, including the US, had bought into it even before it was published. In the four months since then it has done the closest thing possible in development finance circles to going viral.

At the World Bank and International Monetary Fund annual meetings in Washington in October it was widely discussed, helped by the backing of Janet Yellen, US treasury secretary, who asked the World Bank Group to develop an “evolution roadmap” taking into account its recommendations by December.

Conversations about how to respond have continued. “Our panel has had a number of discussions with different shareholders that have been quite positive,” says Chris Humphrey, a senior scientist at the ETH Zurich university who has been pushing for change in MDB capitalisation for years and sat on the panel. “They need time to think — these are complicated topics that involve rethinking issues about how MDB finance has long been managed. But there definitely seems to be an openness on all five of the sets of recommendations.”

The report was also discussed at the COP 27 climate summit, and the V20 group of 58 climate-vulnerable nations has called “on the World Bank and other MDBs to implement all of the recommendations in the G20 expert panel that confirms that such development finance institutions can significantly expand their financing without jeopardising their credit ratings”.

As Humphrey points out, this debate “gets past the old, stale opposition between borrowers and non-borrowers. There is a lot of support on all sides, which gives optimism that there might be change. The shareholders are also aware they need to be active — this is not something they can just turn over to the MDBs and wait for a response.”

Caution baked in

The forces of inertia are so strong that a concerted international process will be needed to drive reform.

The MDBs are directed by boards of governors, usually ministers or top civil servants, but they meet only a few times a year. Day to day, the organisations are run by boards of executive directors, typically slightly less senior civil servants. But while they spend much or all of their time working on the MDB, many are rotated out after, say, three years, making it difficult for them to really get to grips with the issues facing the organisation. Very few have banking experience.

And all the time, the executive directors are torn between wanting to serve and optimise the MDBs they work at and furthering the political objectives of their governments.


The balancing act can be particularly difficult for representatives of developing countries. On an MDB’s board, they are acting for the lender — but they also represent their home countries, which are the bank’s often very needy borrowers.

“The governance is so messed up,” says one MDB official, alluding to habitual confusion and delay.

Beneath the boards are the MDBs’ staff, who do understand how the organisation works and are fairly united behind its objectives, but are ultimately controlled by the boards.

They have to try and work out what strategy the shareholders want them to pursue when the shareholders themselves may not know, or may be disunited.

In such circumstances, it is natural that the default stances of most of the players, but especially MDB staff, are caution and conservatism, bordering on stasis. Certainly, it is not an ecosystem in which it is easy to introduce new ideas or change long-established practices that are known to work — especially in the sensitive area of risk.

As an example, Nelson says, one way to expand an MDB’s headroom, would be to change the calibration of its models, for example from requiring management to have 99.99% or 99.97% confidence that its capital was sufficient to meet its business needs, to 99.94% confidence.

“That would give more capacity,” says Nelson, who was a member of the G20 panel. “Management could decide to do this. But this is not the right transparency you want with your shareholders. MDB management are not going to take the risk of a rating downgrade or capital shortfall unless their shareholders say ‘you can take a bit more risk’.”

If the message from shareholders, Nelson says, is “‘You are triple-A, don’t you dare lose it, and don’t touch callable capital’ then that is what management will do. And they’ll add in buffers for concentration and counter-cyclicality. Shareholders and board members need to build a consistent communication and message to the banks, otherwise banks are always working with a variable level of representatives and will always do what they can to protect the institution. If shareholders say ‘take more risk’, there needs to be a clearer dialogue and understanding of what that means and what it would take for a bank to get into great difficulty.”

Bringing people together

Building that constructive dialogue, which can break down the walls between different constituents who do not communicate well, is now the central thrust of the reform advocates.

The G20 panel, led by its chair Frannie Léautier, a former senior World Bank and African Development Bank official who is now CEO of SouthBridge Investments in Kigali, is busy talking to all the stakeholders and producing follow-up research and guidance documents to support its proposals.


India, which takes over the G20 presidency in January, is set to continue the work, backed by Italy and Indonesia before it.

Ironically, private philanthropists, rather than governments, are offering to pay some of the MDBs’ costs in exploring new approaches. The Rockefeller, Gates and Soros family foundations have created a $5.25m MDB Challenge Fund specifically to pay for work to implement the panel’s ideas.

One of the central issues to grapple with is the extent to which the MDBs are the same as each other, or different.

Each one is a separate foundation, independent of the others. But they clearly belong to the same class of organisations, with common shareholders, rating agencies and investors.

There are two channels for progress: the individual institutions and the system as a whole.

“The work that is ongoing, institution by institution, is really important,” Léautier says, “because first of all they don’t define risk in the same way. They have different ratios of paid-in versus callable capital, unique geographies, so there is a necessity to work through, MDB by MDB.”

Several senior MDB executives told GlobalCapital in October this issue was not a “one size fits all”.

One voice

But Léautier points out three areas where MDBs will have to work collaboratively. “First, the definition of risk appetite. They have common shareholders, so for them to be able to make the right capital allocation decisions it’s important to see the commonality,” she says.

If governments are to consciously take more risk, they need to be able to compare risks transparently across the MDBs they participate in.

The second issue is callable capital. Collective action is essential, because the crucial question is governments’ attitude to this capital.

While the African Development Bank and Inter-American Development Bank do use callable capital to improve their ratios somewhat, the vast majority of the hundreds of billions committed are achieving nothing.

To get more benefit — any benefit — from them, countries will have to communicate clearly to the MDBs the circumstances under which callable capital could be used, and precisely how much cotton wool they want it to be wrapped in.

That message will also need to be conveyed to the rating agencies. If the MDBs and shareholders work together, Léautier says, the rating agencies “will view this as a directed, strategic effort by shareholders. If each MDB goes on its own, it doesn’t give the same importance or gravitas. We think it will give [the rating agencies] a much more favourable view.”

The third area for collaboration, Léautier argues, is that “by working together on [financial] innovations, MDBs will speed up learning. It will help them face the markets, get better pricing from the markets for innovations, and get better understanding from the rating agencies.”

So far, MDBs seem set to continue devising their own innovative transactions and structures separately. A rash of new deals is in the works (see separate article), but the big impact will come in two or three years if they succeed and are scaled up.

Headroom in sight

With a genuinely concerted and intelligent push from shareholders and the right forms of inter-MDB co-operation, there is a real chance that the sector could find ways in the next few years to make its capital go substantially further.

That would lead, as the extra lending capacity was deployed, to an increase in senior bond issuance.

And there are many other ways, besides their capital instruments, for the private sector to give power to the MDBs’ arm. Calls from policymakers and investors for more blended finance structures are getting louder all the time.

In September, the Net Zero Asset Owners’ Alliance, a group of insurance companies and pension funds with $11tr of assets, appealed for “donors and philanthropic organisations to pool catalytic capital” to de-risk green development projects, raising them to investment grade so institutions could invest in them.

A simpler solution for institutional investors willing to be braver is structures like the ILX Fund, set up in the Netherlands by Manfred Schepers, former CFO of the EBRD.

ILX was launched in January 2022 with $750m and now manages $1bn from three Dutch pension funds. It co-invests in deals alongside the MDBs, paying them a fee for their origination work, but taking the full risk without any credit enhancement.

The pension funds need to get comfortable with the level of risk on development finance loans. The truth is, the risk is quite low, and they can earn a double-B level of return.

Unfortunately, most large investors have long been afraid to try this kind of lending, even though they could see by reading the MDBs’ annual reports how low their losses are.

Investors need more convincing. The answer, as most experts including the G20 panel agree, is to give them more detailed data on MDB loan performance.

Since 2009 the MDBs have been working on a joint database called Gems to share this kind of information. For many years some of the members were reluctant to let the outside world see it.

In 2021 they published a report with details on MDBs’ default rates. But investors including the NZAOA have said they need more detail, including recovery rates.

“We strongly support the [G20 panel’s] recommendation that more information should be made public,” says Hassatou N’Sele, chief financial officer of the African Development Bank. “It’s going to have an impact on the pricing of risk transfer transactions. Despite a challenging economic and geopolitical context, our risk transfer portfolio has been performing. The track record of performance should provide investors added incentives to invest.”

Loss-given-default information “will be included as well,” she says. “We are informed by what the market needs.”

Nelson argues Gems “needs work, to be put on a proper footing in order to produce usable statistics and analytics on a sustainable basis. It needs to determine the basis for sharing this with a wider market.”

Helped by more transparency about the risks and rewards of development finance, Turner, now a senior adviser to the Eastern and Southern African Trade and Development Bank, is convinced the model of ILX — whose investment committee he sits on — could be vastly expanded. “We have proof positive it is possible if it is structured the right way,” he says. “Why couldn’t Canada’s pension funds be co-financing alongside the MDBs? Why not the UK ones? Very quickly the problem is not going to be ‘is there enough capital?’.”

Boots on the ground

But what if capital is not the limiting factor on the MDBs’ expansion? There are certainly signs that, for many MDBs, it is not — such as their lack of enthusiasm for balance sheet optimisation techniques up to now.

Nelson, recalling her time at the EBRD and discussions in the network of MDB chief risk officers she helped set up, says: “Most of us did not have capital pressure.”

For many MDBs, the bigger difficulty is finding enough suitable projects to invest in.

“The reality is there is a humongous need out there but a lot of it is for grant or charity-type investment, not debt,” Nelson says. “Education is generally not a bank-financeable sector. It is hard to find a cashflow to pay you back. A hospital can be financed but in many cases repayment falls under government or municipal budgets.”

The major task, especially for MDBs that work with the private sector, is “finding projects that fit all the criteria. Firstly, generate cashflow to pay the loan back, and if they default there is collateral that can be enforced, assuming the judiciary system works,” Nelson says. “Finding bankable projects which then can pass all the other hurdles, including the impact assessment and safeguard tests on governance, environment, social and increasingly climate, integrity clearance, etc.”

Nelson gives the example of a chicken and egg farm in Russia that the EBRD was looking to lend to. As part of the transition efforts and to make it financeable, the farm had to redo its accounts under IFRS and perform an environmental audit.

The EBRD would provide a grant for that, “but to undertake it is a lot for a small company. You can say the same for smaller governments — it takes a huge amount of time. On the sovereign side a lot of projects aren’t structured to be financeable.”


Most of the MDBs, including the EBRD and World Bank, have created departments to prepare projects for financing.

“When people say there is so much need, they are right,” says Nelson — “but how do you get [projects] in shape? That is still a huge challenge today.”

No easy options

Cutting corners on standards and due diligence is not the answer. In 2015 the International Finance Corp was sued in US federal court by a group of fishermen and farmers in Gujarat whose livelihoods had been affected by warm water and coal dust from the 4.1GW Tata Mundra power plant, for which the IFC had provided a $450m loan.

Because MDBs are expected to act for the public good and uphold the highest standards, any lapses tend to cause outrage.

“MDBs can’t afford to get it wrong too many times, because if you damage belief in the banks, you kill them,” Nelson says. “Those mistakes can happen, but they are likely to happen more when you’re stretching staff.”

The MDBs face two issues consistently, Nelson argues: “One is finding projects, and two — if you want us to do more, you need to give us room to hire more people.”

The MDBs’ work is necessarily labour-intensive, giving them high cost-income ratios. Nevertheless, they are generally profitable. The AfDB’s net income, for example, has fluctuated between $41m and $176m in the past five years — enough headroom for a significant increase in its annual administrative costs of $215m.

But MDBs are not free to spend their profit as they choose, such as on hiring more staff. They have to keep costs within budgets approved by shareholders.

And shareholders are often reluctant to let the banks spend more — especially when the government ministries that oversee them are having their own budgets curbed or cut.

“I believe this whole dialogue about the MDBs doing more needs to start with shareholders being clear about their risk appetite and objectives,” Nelson sums up. “You can get rid of risk [through risk mitigation], but you will have more projects in the portfolio and a duty of care. If you need to grow, you need more staff, across all functions. That understanding has to grow at government level.”

Moving the frontier

Does that mean the MDBs in general, if they create more capital headroom through efficiencies, will find they have nothing to lend to?

Asked whether the MDBs might be pushing on a piece of string, Turner says: “I don’t think so. In any system there is a binding constraint. Capital maybe has been, but we will find solutions to it. Once you trigger pathways for the private sector [to invest], the capital is limitless. That is no longer the binding constraint. It moves to something else. It will very quickly be pipelines.”

There is no shortage of need, since trillions of dollars need to be invested in developing countries. “The project pipeline is a pyramid,” Turner says. “People are interested in the top of the pyramid — the most bankable deals. The question is: how do we get projects below that up one level to bankability?”

Rather than soaking up the first loss risk in bankable deals to make them investment grade, Turner argues, which was basically giving free money to the private sector, donors’ concessional money should be concentrated on project preparation.

“MDBs are not well suited to project development,” he says, referring to poor accountability. “The next set of institutions that need to be created are project development companies. [Donors should] seed the private development world with money. Get these private firms doing it and remunerate them based on success. If they get it right, they can make good money — if they get it wrong, they lose their shirts.”

Companies that specialise in this area already exist, as do publicly backed organisations such as Africa50, set up by African governments.

Back to basics

Those who are eager for reform of MDBs to multiply their development impact agree on many things — but not all. Some, for example, are enthusiastic about securitization and insurance, others suspect they are expensive.

The MDBs’ preferred creditor status (PCS) is a thorny issue. By convention and for strong reasons, countries very rarely default on debts to multilateral institutions, even when they have to restructure their commercial bonds and loans.

This means the credit risk of a developing country when held as an MDB loan is lower than when embodied in a bond. For private sector borrowers, the incentive to honour PCS is lower, and unlike governments they can go out of business.

But even for sovereigns, PCS is not a legally enforceable obligation. External stakeholders like rating agencies and private investors can therefore be unsure how much to trust it.

Convincing them to accord proper weight to the benefit of PCS is an important part of increasing private sector confidence to support the MDBs.

But Humphrey is worried this and financial innovation could be taken too far. “Some shareholders might think ‘maybe we can just change the whole model of the MDBs and just originate to distribute,” he says. “They don’t need any more capital, we will just distribute to the private market.’ But that undermines the status of the MDBs, because they just become deal makers for the private sector.”

Using PCS to benefit private investors, which would especially happen if they shared the MDBs’ sovereign exposure, would weaken the grounds for PCS to exist at all, he argues. “They are unique, official institutions. There is a special relationship because the borrowers are shareholders. We need to keep that.”

Rather than thinking capital optimisation is the answer to all the MDBs’ problems, Humphrey says, the shareholders should be challenged to simply put more capital into the MDBs.

It may seem obvious, but it might be easier than devising clever ways to make the market rely more confidently on complex instruments that no one expects ever to be used.

“There seems to be movement in the direction of more capital,” Humphrey says. “There does seem to be building momentum for it. I think it will in the end be part of the package — innovations, the reforms we are pushing and fresh capital, which to me makes sense.” GC

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