MDBs’ extra-cautious capital models attract scrutiny
The G20 has given hope to those wishing to see multilateral development banks increase their lending by stretching their capital further. If a breakthrough is made, ratings will be a crucial part of it.
Hopes are rising that a longstanding paradox that limits multilateral development banks’ lending could be tackled. MDBs’ balance sheets are extremely conservative — even more so than necessary to support their triple-A credit ratings. Despite the apparently urgent needs for finance in developing countries and the MDBs’ mandate to provide this, they lend less than they could.
Since 2015, the G20 has been calling on the MDBs to expand their activities, by making their capital go further.
Five years ago, Standard & Poor’s concluded that, other things being equal, the 19 MDBs it rates could expand their lending by $1tr, or two thirds, without being downgraded.
Now, in a communiqué on June 24, the G20 said it was considering reviewing the issue of capital adequacy — something informed observers have wanted for years and which they believe could produce a breakthrough.
“The MDBs have very conservative capital adequacy policies — more conservative than necessary,” said Nancy Lee, senior policy fellow at the Center for Global Development in Washington. “During crises they should use their flexibility to decrease their equity to loan ratios.”
The problem arises from the unique capitalisation and governance arrangements for MDBs.
Governments have set up MDBs to promote development, but have often been stingy about handing over capital. Hence, much of the banks’ capital is not paid in, but callable — meaning they could ask their shareholders to provide it if they ever needed it. No MDB has ever called on it.
The de facto regulator for MDBs’ balance sheets is the rating agencies, which give them the triple-A grades that unlock very cheap funding.
The rating agencies do not give full credit for the callable capital — but they do give some. However, the MDBs act as if they got no credit — as if the callable capital was not there.
“The MDBs all say callable capital supports their bond ratings, but in the models where they work out their capital adequacy, which determine how much they lend and when they need more capital, they do not include callable capital,” said Chris Humphrey, senior scientist at the ETH Zurich university, who has been writing about this issue for several years.
In the European Bank for Reconstruction and Development’s balance sheet for end 2020, for example, its capital is listed as €6.2bn of paid-in capital and €11.7bn of reserves and members’ equity. Its €23.5bn of callable capital is only mentioned in a note.
That €17.9bn of usable capital supports €51bn of loans, advances to financial institutions and equity investments — a ratio of 2.86. The bank has also extended €15bn of undrawn commitments. Its non-performing loan ratio is 5.5% and net loan losses last year were €37m.
Exactly why MDBs are so cautious about capital adequacy is puzzling, but experts suggest two reasons. “The wealthy country shareholders have long supported the MDBs having extremely conservative financial policies, because they are afraid their callable capital might some time get called,” said Humphrey. “The callable capital was put there so the MDBs could take more risk, but it’s become an excuse for them being more conservative. Now the shareholders including the wealthy countries want the MDBs to do more.”
The US had traditionally been cautious, but with Joe Biden as president is eager to press for more action by the MDBs.
The MDBs themselves have been timid, to avoid upsetting their shareholders or imperilling their ratings. But Humphrey added: “They like their autonomy. They don’t have any regulators, so they’ve opposed [change]. Now they’ve begun to tell which way the wind is blowing and are contributing in a positive sense.”
The crucial factor will be the attention of the G20 — which since the 2008 financial crisis has been a vital organ of international financial governance.
Its communiqué said its International Financial Architecture Working Group was “laying the ground for an ambitious package of measures to make available more development finance and strengthen co-ordination among international financial institutions”.
As part of this, the IFAWG has discussed “a possible review of MDBs’ capital adequacy frameworks, [which] could free up additional resources for low and middle income countries.”
Since the group’s role is to prepare for ministerial decisions, the next step could be for G20 finance ministers to initiate this review when they meet in July.
The package has two other promising elements. First, “the full support of the G20 to advancing an early replenishment” of the International Development Association, the World Bank arm serving the poorest countries. During the Covid pandemic last year, IDA more than doubled its annual commitments, but this left it needing a replenishment a year earlier than planned.
Second, the IFAWG discussed MDBs’ balance sheet optimisation measures. This refers to securitizations and credit insurance transactions — as pioneered by the African Development Bank in 2018 — and exposure swaps, which make the MDBs’ capital go further.
Experts believe there is considerable potential for more such deals, and investor appetite. But progress was halted in 2018 by the US Treasury, which criticised balance sheet optimisation. The IFAWG talks suggest the new US administration has thawed on this.
The G20 is not poised at this stage to regulate the MDBs. Nor will it tell the rating agencies what to think.
But Humphrey believes there could be value in “having an external, official view that might encourage methodologies to converge”.
That could include guiding the MDBs’ finance departments on how to manage their capital adequacy, as well as the rating agencies.
Rating the MDBs is difficult because they are so unique. This leads to the agencies having very different methodologies, which are tricky for the MDBs to navigate.
When he wrote about the issue before, Humphrey said, “the rating agencies said we don’t know what to rely on — we would be happy if there was some external position”.
The G20 could help them interpret some of the difficult concepts.
S&P’s analysis in 2016 that the 19 MDBs could add $1tr of assets provoked complaints from them, so in 2017 it published a clarifying statement. The actual headroom could be lower, depending on factors such as government shareholders being downgraded.
For an AAA rated MDB, S&P counts callable capital from governments rated at least AA+. This is factored in at the end, and can give up to three rating notches of extra credit.
First, S&P rates the organisation without counting this, producing a standalone rating.
“As of October 2020, AfDB was aa+ by S&P as a standalone rating,” Humphrey said. “ADB, AIIB, EBRD, EIB, IDB, IFC and IBRD were all aaa standalone.”
That means most of the big MDBs are wasting up to three notches of potential rating headroom.