Amid climate change and pandemic stresses, multilateral development banks can free up billions of dollars

Can multilateral development banks loosen risk policies to provide larger-scale, low-cost financing while serving developing nations well?
To start with, the banks could leverage their deep knowledge of country risks to make better use of their guarantee products, instead of focusing on loans

Grant Hauber

Published: 9:30pm, 4 Apr 2023

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Between pandemic stresses and formidable climate change needs, demands on multilateral development banks (MDBs) are peaking. Questions have arisen over whether they can do more with the money and tools they have, or if major reforms are required.

Last July, a report commissioned by the Group of 20 suggested ways to overhaul MDB risk management practices to make tens of billions of additional dollars available to member countries. Proposals range from more aggressive risk capital treatment, to selling non-voting shares in MDBs and selling risk participation in MDB assets to private third parties.

The impact of these measures on MDBs is unclear. It may be neutral. It could result in credit rating downgrades, thus increasing borrowing costs. It could lead to a general capital call among MDB shareholders, something many governments may not be in a position to entertain.

In February, it was reported that a group of dozens of mostly developing economy governments wrote to World Bank executives calling on them to retain their tight risk management policies. These countries want to preserve the bank’s ultra-high credit rating so they can continue to access low-cost capital, according to the report.

Thus, a dichotomy exists: can MDBs simultaneously loosen risk policies to provide low-cost financing at a larger scale while serving their developing-economy clients well?

Most MDBs have maintained AAA credit ratings since their inception. They keep in reserve large callable capital commitments from shareholders. Among long-established MDBs, the ratio of paid-in to callable capital ranges between 1:15 and 1:20, a formidable cushion. Never has that contingency been called. MDBs concurrently enjoy “preferred creditor treatment” where a borrower country under financial distress would prioritise MDB obligations.

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Such backing provides credit rating agencies with comfort to maintain MDBs’ top ratings, consequently allowing them to tap capital markets with minimal margins. Last month, the World Bank issued a US$5 billion, seven-year bond at 0.17 per cent over similar US Treasuries, almost the same as the US government itself.

This indicates MDBs have significant headroom to stretch their risk appetite without downgrades. Nonetheless, MDB risk tolerance should align with evidence-based, pragmatic assessments of risks posed by operations and be less guided by a rating. Which stance will find favour with MDB shareholders lies at the heart of the debate, so a compromise could take significant time to agree.

Indonesia’s President Joko Widodo (centre right) passes the gavel to India’s Prime Minister Narendra Modi in a handover ceremony during the G20 Leaders’ Summit in Bali, Indonesia, on November 16, 2022. A report commissioned by the G20 proposed ways multilateral development banks can overhaul their capital adequacy frameworks, but countries, including India and Indonesia, have urged the World Bank not to undertake reform that would jeopardise its AAA rating. Photo: EPA-EFE

While proposed reforms take shape, one near-term action MDBs could consider is to make better use of their guarantee products. MDBs can credibly manage country risks due to robust relationships with member governments and deep knowledge of their political, fiscal economic and social evolution.

Unlocking MDBs’ potential as a guarantor involves leveraging their unique country-level experience against their underexercised buffers by accounting differently for guarantee risk and the capital behind it. This can free up billions of dollars without additional capitalisation or jeopardising credit status.

Currently, most MDBs treat US$1 of guarantee the same as US$1 of loan, without risk differentiation. With a loan, the MDB has full control over all aspects of its origination, structuring and monitoring but is exposed to all risks. A guarantee, by contrast, covers a subset of risks, like changes in political policy or regulatory oversight, on someone else’s loan.

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If a guarantee eats up as much risk capacity as a loan, the MDB will always prefer to execute loans. As a result, guarantees are rarely used, totalling little more than 2 per cent of business among the longest-established MDBs.

A guarantor may need to pay out the full value of the loan it covers; however, the probability that a covered risk will lead to such a payout is low. Insurers have taken this approach from day one. MDBs possess decades of performance data on their borrowing countries, invaluable information that can be converted into actuarial adjustments to risk capital then shared with credit rating agencies to support expanded use of guarantees.

A man takes pictures of two ships which were pushed out onto the Costanera highway by a tsunami wave after the September 16 earthquake, in Coquimbo, Chile, in 2015. In March, the World Bank listed a US$350 catastrophe bond on the Hong Kong exchange that provides the government of Chile with financial protection against severe earthquake events for the next three years. Photo: EPA

Incorporating experience-informed metrics with guarantees, MDBs could leverage risk capital at 5:1 or even 10:1. If an MDB’s annual risk capital allocation for a country is US$100 million, instead of doing a single project loan in-house, with guarantees it could catalyse US$1 billion in loans from other financiers, funding multiple projects. Applying this actuarial approach to the meagre US$11.8 billion guarantee provisions now on the books of MDBs could mobilise US$100 billion of investment.

In the age of multibillion-dollar energy transition mechanisms, where private-sector participation is a must, taking major swathes of political and country risk off the table could mean the difference between success and failure. A probability-based approach to guarantees, akin to insurance practice, could unlock great potential.

MDB guarantees would provide the comfort that reluctant but interested investors and lenders need to throw their support behind the transition – a game changer. The beneficiary country is happy, private-sector participants are assured, and the MDBs can do more.

Grant Hauber is a strategic energy finance adviser at the Institute for Energy Economics and Financial Analysis (IEEFA)

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