Reform and innovation in the MDB sector continue to accelerate. The World Bank has become the first multilateral development bank to announce plans for ‘enhanced’ callable capital and has found a way to lower again its cherished equity-to-loan ratio — both of which should create space for more lending. But many difficult questions remain unanswered about the MDBs’ governance and financial management.
The World Bank’s president Ajay Banga surprised many by making one of the Bank’s biggest announcements planned for these Annual Meetings a week early.
Blazoning the eye-catching figure of $150bn more lending over 10 years, the Bank said on October 15 it would lower its minimum equity-to-loan ratio from 19% to 18%, cut some fees for borrowing countries and make its loans to small nations cheaper.
More is to come this week, with two or three more countries preparing to announce commitments to buy hybrid capital issued by the Bank’s sovereign lending arm the International Bank for Reconstruction and Development.
Bank watchers will have to wait much longer for the first public issue of hybrid capital — though work continues on the project.
Vital ratio
The equity-to-loan ratio is one of the IBRD’s most important financial metrics, controlling how much lending it can do. For many years it was stable, well above the Bank’s policy minimum of 20%.
Between 2019 and 2023 it gradually declined from 22.8% to 22% as loan balances grew. Then in April 2023, the Bank said for the first time that it would allow it to fall as far as 19%. As of June 2024 it was 21.5%.
This gave the IBRD leeway to commit to another $40bn-$50bn of loans over 10 years, or $4bn-$5bn a year. In 2023 it committed $38.6bn.
Cutting the ratio to 18% will allow another $30bn of financing over 10 years.
The Bank has got comfortable with that by creating a new set of processes internally, to protect its triple-A credit ratings from Moody’s, S&P and Fitch.
Systems have been set up to monitor credit quality metrics followed by the rating agencies. Should these weaken to a certain point, the World Bank will enter a ‘warning zone’. Shareholders will have nine months to act, according to a board paper produced last week, for example by injecting more capital — to stop the Bank moving into a worse ‘hazard zone’.
If shareholders fail to act, the Bank’s management will automatically be empowered to start a series of actions to restore its credit strength. These could include slowing down loan origination, raising loan pricing by 50bp, ceasing transfers of surplus to the concessional International Development Association and cutting administrative costs.
“It’s a terrible thing to do to clients — which is why we will have enhanced monitoring systems and other measures of prevention so hopefully we never get to that point,” said George Richardson, director of capital markets and investments at the Bank in Washington.
Crucially, these systems are designed to prevent even a negative rating outlook from one of the agencies.
“For an issuer the size of the IBRD even a negative outlook would be a big problem,” said Richardson. “It would impact our market access. That’s a problem for a big issuer like ourselves, doing large benchmark bond deals almost every couple of weeks.”
He referred to an incident in 2011 when false rumours about the European Investment Bank had widened its spreads and impaired its market access.
The Bank already had all these levers to de-risk its balance sheet if it were in trouble, like other MDBs. But they were previously not automatic — using them would have required conscious policy decisions in the heat of the moment.
Responding to CAF
These measures are part of the Bank’s response to the Capital Adequacy Framework report, commissioned by the G20 and published in 2022, which won strong support from shareholders.
One of the CAF panel’s top recommendations was that MDBs reform how they value and use callable capital — capital pledged by members, but not paid in. At the IBRD this is 93% of total capital, and is not counted in the Bank’s usable equity for leverage purposes.
The panel argued this was wasting a huge resource. Callable capital was not as valuable as paid-in, but should be worth something in the balance sheet, they urged.
“The CAF report spent far too much time valuing callable capital as good for leveraging,” said Richardson. “It’s not meant to increase lending, it was designed for something else. MDBs cannot call callable capital until the end [of their ability to function], when they need it to repay bondholders. At that point, we would call it and that money can only go to senior bondholders.”
Heike Reichelt, head of investor relations and sustainable finance in Washington, said the Bank’s response to enhancing the value of callable capital had “three pieces. First, lowering the minimum equity/loan ratio to 19% by decreasing the stress test confidence level, which means relying more on callable capital for our capital metrics. Second, we published our report in April which detailed what each country had to do to pay in callable capital.”
The research showed shareholders had a total of $65bn of callable capital that could be paid without needing fresh parliamentary approval.
“The third piece was introducing enhanced callable capital,” said Reichelt.
Taking the lead
MDBs’ chief risk officers have worked together on enhanced callable capital, but the World Bank is the first to announce it will create it.
A number of countries have begun talking to the World Bank about participating, though none has committed yet.
The concept is to make callable capital more useful by changing its terms, so that it would be called at a much earlier stage in the World Bank getting weaker — in fact, when the Bank was in imminent danger of losing its triple-A rating.
Countries that wish to will be able to replace up to 16% of their existing callable capital with the enhanced version.
The World Bank intends to leverage ECC from countries rated above AA- six times over 10 years. Single-A rated commitments will be leveraged 4.5 times.
“It’s the beginnings of another product,” said Richardson. “With all the other products we have rolled out over the past year, we’re now at the cutting edge of balance sheet management.”
Chris Humphrey, a senior research associate at the Overseas Development Institute and member of the CAF panel, said enhanced callable capital was “an interesting initiative”, but he is worried it could be taken as a reason for the MDBs to give up on reforming treatment of callable capital as a whole.
More important than new add-on techniques, he said, was to create a collaborative forum of all the MDBs and their shareholders, to establish with authority how much risk paid-in and callable capital should be able to bear — equivalent to the role played by the Basle Committee for commercial banks.
This should be based on their own understanding, not that of the rating agencies, he said. “They should say ‘we think we have this much lending space’. Then look at the rating agency models. If they don’t agree, everyone knows what the problem is.”
Letting the rating agencies effectively dictate policy to the MDBs was the wrong way to go, Humphrey said.
Shareholder hybrid money arrives
Shareholder hybrid capital pledges have passed $1bn, with Canada adding $200m in June to the pot offered by Germany, the UK, Denmark, Italy, Latvia, the Netherlands and Norway. They are set to reach $1.1bn in a few days with two or three more countries announcing. There is a pipeline of further contributions.
The World Bank has committed to issuing a $1bn pilot of hybrid capital in the public market.
The structure is basically ready and the Bank has done several roadshows to discuss structures with investors.
“We’re ready to go, but the market is not there and we’re not going to do a bond that doesn’t work,” said Richardson. “The product needs further development — tweaks to make sure it’s something that appeals to actual hybrid capital investors.”
The spread on the AfDB’s hybrid has widened in the secondary market to a level that the World Bank would not want to pay. The Bank is concerned this could be because investors are worried an MDB would not be incentivised to call a hybrid bond if it were cheaper to leave it outstanding, creating extension risk.
“We are not waiting for the market for MDB hybrid to improve on its own,” said Richardson, “we are actively trying to develop the right solution.”
An extended, in depth version of this article is available at GlobalCapital.com