G20 tells MDBs: take more risk and grow

The G20 gave a hard shove this week to the multilateral development bank system, whose wheels are grinding slowly towards reforms that will expand their balance sheets and introduce more innovative capital structures.

Already at least four major MDBs are preparing to issue hybrid capital, GlobalCapital understands, and the sector’s leader, the World Bank, has indicated its willingness to enlarge its loan book, relative to its equity.

Calls for change in the MDBs, to increase their lending power and flexibility to tackle the severe problems besetting development countries, have been mounting over the past few years, but the organisations are inherently conservative and their unusual governance makes it very difficult to alter their habits.

A breakthrough came last year with the publication of an Independent Review of MDBs’ Capital Adequacy Frameworks (CAF) by a technical expert panel reporting to an arm of the G20. It has been influential, winning powerful backing including from US treasury secretary Janet Yellen, and allowing supporters through persistent lobbying to gradually lever open doors to reform.

This year, India as president of the G20 has commissioned another report, which was presented to the G20 finance ministers’ and central bank governors’ meeting in Gandhinagar this week.

“To transform development, the MDBs will have to transform themselves,” it said. Among its demands was that MDBs “must get shareholders to understand that public capital has to take on more risk”.

The new inquiry has two advantages.

It was conducted by high profile political and public figures, led by Larry Summers, former US treasury secretary, and Nand Kishore Singh, chairman of the Finance Commission of India. Members included Lord Stern, the UK climate economist, and Arminio Fraga, former governor of the Central Bank of Brazil.

Second, its remit was much broader: it studied not just capital adequacy but the MDBs as a whole.

Only the first volume of the report has come out — the second will follow.

“This volume did what it really had to, which is focus people’s attention on the scale of the MDB system as a whole, with some pretty dramatic numbers of how short of the needed scale it is,” said Nancy Lee, director for sustainable development finance at the Center for Global Development in Washington. She was one of 13 technical advisers to the panel.

The report is strongly worded and exudes determination to bring about change.

It states that, by 2030, $3tr of additional spending will be needed every year in developing countries, of which $1.8tr will be for climate action (a fourfold increase from 2019) and $1.2tr for other UN Sustainable Development Goals, including a 75% increase in health and education spending.

Of this, one sixth, or $500bn, should come from official international development finance: one third ($165bn) of it as concessional funding and grants and two thirds ($335bn) as non-concessional official loans.

This $500bn should mobilise and catalyse another $500bn of private capital.

Of the extra official finance, the G20 panel said the MDBs should provide $200bn of non-concessional lending and $60bn of concessional.

To put that in context, last year the World Bank’s IBRD made $33bn of commitments and disbursed $28bn. The biggest country recipients of commitments were India with $4bn, Indonesia ($2.6bn) and Colombia ($2.1bn). The Bank’s concessional arm the International Development Association committed $38bn and disbursed $21bn. The private sector-facing International Finance Corp paid out $13bn.

The Asian Development Bank disbursed $20bn, the IADB $12bn and the African Development Bank $4.7bn.

These are not the only MDBs, but compared with these six, the $260bn of additional funding called for is 2.5 times the existing run rate.

Some of the MDBs’ major shareholders — essentially, rich countries — may be taken aback by the size of demands for them to increase development aid and support for the MDBs.

But Lee said: “It’s useful to look at the overall investment needs and compare them to the size of the MDB system. Shareholders often just get bogged down in discussions of an individual capital increase, with no bigger context.”

She said the timing was favourable for the report’s recommendations to be implemented. The presidency of the G20 is in emerging market hands, having passed from Indonesia last year to India this, with Brazil and South Africa the next two to take the reins.

A Democratic administration enthusiastic about reform is in power in the US, and following the early exit in February of David Malpass, who had been nominated by former US president Donald Trump, Ajay Banga has taken over as president of the World Bank.

He was nominated by Yellen and has already impressed reform advocates with his enthusiasm for change.

One of the core issues in the debate is how much risk the development banks take. That includes how much they lend, relative to their equity, and the nature of loans they provide.

The World Bank, as the most influential MDB, has always contributed to what critics see as the sector’s excessively cautious approach to this complex set of questions.

One basic measure is its equity to loan ratio, which for IBRD has gradually declined from 22.9% to 22%. That implies now $4.50 of loans for every $1 of what the Bank defines as usable equity, totalling $50.5bn.

For years development advocates have called for the Bank to let this ratio fall, and this year it has indicated a willingness to go to 19% — not far enough, in critics’ eyes, but a start.

Assuming a roughly typical equity growth of $1.5bn this year, that could create headroom for the Bank’s loan book to grow from $227bn to $274bn — another $47bn of loans.

Annual disbursements at the moment are about 12.5% of total loans, so at an even pace that could mean another $6bn of disbursements a year, although it might be possible to bring the extra headroom into play more quickly.

A 19% equity to loan ratio would take the IBRD’s loan book to 5.25 times its usable equity.

No two MDBs are the same, but for the system as a whole, the G20’s Independent Expert Group wants much more than that. It argues $1 of capital at the MDBs should support $7 of direct MDB lending, or an equity to loan ratio of 14.3%.

That multiplier, applied to putative IBRD usable equity this year of $52bn, would allow for $364bn of loans, a 60% increase on the current book.

However, the MDBs cannot just increase lending at will. Their capital models are highly complex and hemmed in by a web of constraints. Changing any of these requires multiple stakeholders to agree, in a process for which there is no forum or precedent.

One of the simplest reforms to achieve could be to introduce hybrid capital to the MDBs’ capital structures.

Last year two African development banks, Banque Ouest-Africaine de Développement and the Eastern and Southern African Trade & Development Bank, nearly brought hybrid deals to market. TDB at least was put off by unfavourable market conditions as interest rates rose.

As GlobalCapital revealed in October, the African Development Bank is preparing a transaction, which it had hoped to execute this year.

This week, the World Bank published a brief statement setting out “New steps to add billions in financial capacity”.

It was clearly designed, on the eve of the G20 finance ministers’ meeting in India, to display the Bank’s willingness to reform by taking “bold new steps to increase its lending capacity”.

Of the four points it mentioned, the second was “Raising hybrid capital from shareholders and other development partners”.

It added: “With $1bn of hybrid capital, the Bank can increase its lending by up to $6bn over 10 years.”

The World Bank could not give any further details by press time, but the numerator in that ratio appears to be loan disbursements over 10 years. GlobalCapital estimates that at present, the World Bank disburses over 10 years about $4.60 for every $1 of average usable equity.

This suggests that the World Bank’s hybrids would be treated by the rating agencies as having high equity content. The African Development Bank’s plan is for an instrument with 100% equity credit from at least S&P and Fitch. Moody’s said last year it would give 75% credit to BOAD’s deal.

Sources said two other major MDBs are also working on hybrid capital plans.

Hybrid capital from the big MDBs would be certain to attract great excitement from investment banks and investors. There is no question investors would buy them — the difficulty would be establishing the right price for this unprecedented instrument.

The hybrids of highly rated commercial banks would be the obvious starting points, but the MDBs are likely to argue hard to be considered as better credit risks, thanks to their ownership by governments, which are obliged to support them if they cannot service their debts, and their risk-averse business models.

Shareholders are the obvious first investors to consider, but they may have quandaries about how to price an instrument that has not been issued in the market. And the real power of hybrid capital for the MDBs would come from issuing to commercial investors, giving the banks a new source of risk-bearing capital apart from their shareholders.

More difficult than issuing hybrids would be changing the MDBs’ capital models. One of the problems is that although their shareholders are a common pool — national governments — the shareholders do not manage the MDBs in a joined up way.

Each MDB’s management knows the most about its own affairs and it is hard for the civil servants and ultimately finance ministers who are their ultimate masters to control and steer them.

The MDBs are "not an asset class, but they're a specific subset of institutions," said Chris Humphrey, a senior scientist at the ETH Zurich university and member of the CAF panel. "They don't have a regulator, there's no Basle 3, nobody quite knows what the standards [for capital adequacy] are. The only ones that can create the standards are the MDBs working together with vocal shareholder support."

Last year’s CAF report has started a long overdue conversation, in which transparency and understanding are beginning to grow, between the MDBs and their shareholders and between the MDBs themselves.

"Cooperation is beginning to happen," said Humphrey. "There is an awareness of the need. It's not yet formalised but it's headed in that direction — there's much more appetite."

Since the MDBs have no central controlling body or regulator, their de facto financial regulator is the three major rating agencies, which give them the ratings they see as essential to being able to provide low cost finance to developing countries.

The MDBs are reluctant to take more risk, for fear of imperilling their ratings, even though there could be huge scope for them to expand lending, even with existing capital, without being downgraded. S&P is quite explicit about this.

The rating agencies do not want to see themselves as overlords of the MDBs, nor to hold back progress. They are trying to do their best to give fair opinions about a unique sector, in which several aspects of governance and financial performance are unclear.

Part of the reason the rating agencies seem like obstacles to the MDBs is that they are so cautious about expressing their views to the agencies, and shareholders have not done so at all.

Each stakeholder has exercised the maximum caution, instead of talking to the others.

There are several avenues for possible progress, in which the rating agencies’ models and MDBs’ capital models could be aligned on more highly geared balance sheets, with senior debt still rated triple-A.

These include how the rating agencies treat the concentration risk in MDBs’ portfolios — a matter of financial modelling which draws heavily on assumptions and empirical evidence about patterns of correlation. Another issue is how the rating agencies give credit for the MDBs’ preferred creditor treatment (PCT), which means they have historically suffered much lower losses when a borrower defaults.

"The way the MDBs evaluate how much risk capital they need per exposure we’ve found to be too conservative because of PCT etc," said Humphrey. "That needs to be adjusted within their capital adequacy frameworks. That remains pending, it's hard to say if anything is happening. We were never able to fully get inside the mechanics of their capital adequacy frameworks and understand how they account for PCT or the concentrated nature of their portfolios."

Studies are being produced on PCT and concentration as follow-up to the CAF report.

But possibly the most important and first area for progress is how callable capital is treated. The World Bank has only ever received $20.5bn of paid-in capital. Shareholders have granted it $307bn of callable capital. But as far as its capacity to lend is concerned, this might as well not exist.

Even though the rating agencies are willing to give some credit for it, the World Bank and most other MDBs have cautiously decided not to use this. What they count as usable equity is all either paid-in capital or accumulated profits.

Humphrey points out that callable capital is not the same as paid-in equity. It is not meant to be there to absorb ordinary loan risk. But it is meant to be a backstop to ensure the MDBs can service their debts if they were ever in difficulty. Shareholders are obliged to pay it if called on, by international treaties that establish the MDBs. And the sums are huge: about $1.2tr in total.

“It has a value," said Humphrey. "I don’t think it’s worth $1.2tr [in additional risk-bearing capacity]. But it’s not zero.”

Real progress is at last being made on this issue. All three rating agencies are willing to engage in dialogue with other stakeholders about it, and more importantly, the MDBs and their shareholders have recognised the need to open that dialogue and are actively engaging in it.

"There is an appreciation that there is a lot of potential there and there's an exploration going on," said Humphrey. "The rating agencies are definitely willing to listen and look at the evidence."

The G20 report calls emphatically for full implementation of the CAF report recommendations, and the World Bank’s statement this week said “Extracting more value from callable capital” was one of its steps to increase capacity.

“Widening the conditions, and clarifying the procedures and mechanism, under which the Bank can call on shareholders, could help the Bank absorb more risk and expand lending," it said. "More work will need to be done together with rating agencies and shareholders to make callable capital more useful.”

The prize is for the rating agencies, MDBs and shareholders to develop between them a fuller and more explicit understanding of what callable capital is and under what circumstances it could be called. That would enable them together to use it more to support lending.

This, together with many other reforms such as more use of risk transfer to the private sector, including insurance and securitization as the African Development Bank has pioneered, and risk pooling among MDBs to improve diversification, are part of the techniques the G20 believe could get MDB loans up to seven times capital.

But they also want the MDBs to do much more to mobilise co-investment by the private sector. On their own figures, they are only mobilising about $0.60 of private lending for every $1 of their own non-sovereign lending. The G20 panel wants them to at least double this.

“Up to now the MDBs have been much more focused on increasing the amount of private sector finance on their own balance sheets than making decisions that maximise the space for private investors [to lend to the same or related projects],” said Lee. “It’s not that they have never been focused on mobilisation, but if you look at the numbers, they’re pretty limited.”

She said there were many ways in which private sector investment mobilisation could apply to the MDBs’ sovereign lending, as well as their loans to the private sector.

If this succeeds, the G20 report reckons every $1 of MDB capital could mobilise a total of $15 of MDB and private investment.

Because of this, Lee said, “the report argues [that] if you are a donor country or large shareholder and looking for a place to put money where it will be most efficiently stretched, MDBs are the place to put it.”

Even with optimal implementation of all these measures, the G20 panel said, the lending power created would not be enough. “We are inescapably led”, the group said, to recommend starting the process for a general capital increase for MDBs with headroom constraints, including the IBRD.

As Yellen has previously said, balance sheet optimisation including capital adequacy reforms is now “a necessary condition” for a capital increase.

“The interaction between the capital adequacy framework reforms and capital increase discussions is something that the report is very clear in articulating,” said Lee. “Clearly the CAF reforms have to be fully executed. You can understand why — if you’re going to your legislature to ask for capital, you’ve got to be able to say 'we’ve got greatly enhanced efficiency of the existing capital'."

But the capital adequacy reforms could take a long time. "So the report responsibly says you can’t wait and make it completely sequential," Lee said. "There has to be the beginning of work on capital increases while the capital adequacy reforms are undertaken.”

Another potentially transformative measure called for in the report is the creation of an independent monitoring group, reporting to the G20, to check up on the MDBs’ progress on reform.

This could fill part of the governance vacuum that has hindered change for so long.

Lee called it “a very good idea. It offers continuity of G20 MDB reform oversight based on an objective independent assessment. Since the presidency of the G20 changes each year, the G20 agenda changes and continuity can be lost.”

Last year the CAF report opened a new era for the MDBs. After a year of some initial resistance from some of the MDBs and intense advocacy by the CAF panel members including its chair Frannie Léautier, and growing support from shareholder governments, the MDBs now seem on the verge of substantive change, and to be willing partners in it.

Lee said: “Right at this moment when the effects of climate change could not be more obvious and widespread, and are directly felt by developed countries and well as developing countries, this is a good time to use that rising anxiety to offer a solution.”