The financial capacity of the World Bank and the other major multilateral development banks will be central to conversations this week at the Annual Meetings in Washington, on how to meet global development and climate investment needs.
A key driver of these debates is the recommendations of the G20 MDB Capital Adequacy Framework (CAF) review of 2022.
A progress report by the G20, due out this week, will show that MDBs have collectively generated $300bn-$400bn in additional lending capacity over the coming decade, through CAF reforms. These gains reflect the extraordinary solidity of the MDB financial model, as well as the potential to modernise it.
MDB management and some shareholders could be forgiven for wanting to declare victory and move on.
But despite this substantial progress, more remains to be done to achieve the true promise of the CAF agenda.
The truth is we still have no clear answer to the basic question of how much capital is adequate for an MDB, for a given volume of lending.
Commercial banks have Basel III-inspired guidelines to orient them on capital adequacy, but MDBs have no regulator. The principal stakeholders — government shareholders, MDB management and capital market actors — still do not have a generally agreed understanding of how much MDBs can prudently leverage their capital.
Because of their need for top bond ratings, MDBs are de facto regulated by major credit rating agencies. The agencies, however, aren’t entirely sure how to evaluate the unique attributes that differentiate MDBs from commercial banks, and as a result have widely divergent methodologies.
Unique attributes
MDBs are different from commercial banks in many ways, but three attributes stand out.
First, the credit risk of MDBs’ loans is extremely low, considering that they mainly lend to low and middle income countries, because MDBs benefit from preferred creditor status (PCS): borrowers prioritise repaying an MDB even if they face financial difficulty.
The benefit of PCS is proven in practice and very substantial. But it is not a contractual obligation and thus difficult to value.
Second, many MDBs have loan portfolios concentrated in just a few borrowing countries, which all else equal should make them riskier.
Of course this is by design: MDBs are non-profit cooperative banks for a group of countries, and they benefit from PCS, so it isn’t clear how much MDBs should need to set aside extra capital for this portfolio concentration. A study in 2023 explored whether current MDB capital adequacy models are too conservative in accounting for it.
Third, if MDBs ever face a very severe crisis, they can tap callable capital, a shareholder guarantee backed by international treaty with a nominal value of over $1.2tr across the 11 major MDBs. Callable capital has never been tapped in the history of any MDB and the procedures for doing so are not clear, which makes it hard to value.
Recently released MDB reports on callable capital and historical loan portfolio performance are steps in the right direction. But more work is needed to build standards for this unique asset class.
Put your heads together
The CAF panel proposed that MDBs and shareholders set up working groups to agree on standards for PCS, concentration risk, callable capital and other aspects of MDB capital adequacy. They should then incorporate them into their CAFs in a consistent way, adapting as needed for each MDB’s circumstances.
The goal is for management and shareholders to design CAFs based on their own collective understanding of risk, not on the methodologies of three different rating agencies — a key recommendation of the Financial Stability Board after the 2008 global financial crisis.
Doing so poses no risk to MDB ratings. MDBs can maintain a target rating and take action to avoid a downgrade, just as they do now. But a rating target should not mean baking rating agency methodologies directly into MDB CAFs, as is currently the case,
Recent rating agency commentary suggests that further action on CAFs could result in additional gains in lending capacity beyond the $300bn-$400bn already achieved. Even if it did not, it would have two important benefits.
First, it would clarify going forward that MDB lending was being constrained by rating agency methodologies, not shareholder risk appetite. Currently many stakeholders are not entirely clear where the problem lies.
Second, it would promote convergence over time toward generally agreed standards to assess the unique financial risks and strengths of MDBs.
Rating agencies would have greater clarity on MDB creditworthiness, encouraging change in methodologies going forward, to recognise the strength of MDB capital adequacy. The increasing number of private actors working with MDBs on blended finance initiatives will have more comfort to mobilise even more resources for development.
Most importantly, debates around the lending capacity and capital needs of the MDBs among management, shareholders and civil society would be on a firmer, evidence-based footing.
These banks are critical to helping us put our planet on a more sustainable path forward — we need a collective understanding of what they can do.
MDBs need to be overhauled in many areas, as the about-to-be released G20 Roadmap on MDB Reform led by the Brazilian government will detail. But modernising their financial policies is central.
Discussions of fresh capital injection should not wait for CAF reforms to be finished — some MDBs need more firepower to match their lending capacity with the ambitious targets set by shareholder governments. The amount of resources needed is very modest in relation to its impact, due to MDBs’ high standards and leveraging ability.
But CAF reforms should continue in parallel, to ensure that every dollar of taxpayer capital is leveraged to the maximum.
Chris Humphrey is a senior research associate at the Overseas Development Institute and a researcher at the ETH University of Zurich. He was a member of the G20’s expert panel that produced the Capital Adequacy Framework report in 2022.