Too Small to Succeed: Reforming the AfDB’s Financial Governance

Why isn’t the African Development Bank Group bigger? Africa’s low country per capita incomes and high poverty rates offer the strongest case for development finance of any continent, but the AfDB Group is the smallest of the major development banks. In recent years, the African Development Fund (AfDF)—the AfDB’s concessional lending window—has actually shrunk. Annual commitments from IDA, the arm of the World Bank that lends to the lowest-income countries, to sub-Saharan Africa now stand at around $15 billion a year, while the AfDF has barely surpassed an annual $2 billion this replenishment cycle.

Even with the inclusion of IDA concessional lending, growth in total concessional lending to sub-Saharan African governments has lagged that of private lending. In the decade leading up to 2017, multilateral concessional lending to sub-Saharan African governments roughly doubled, while private lending tripled. As the clock on fulfilling the Sustainable Development Goals (SDGs) ticks, many already heavily indebted governments are having to choose between even more non-concessional debt or less development. (The IMF estimates that closing SDG-related health, education, and infrastructure gaps in low-income countries would require additional spending of 16 percentage points of GDP on average by 2030. Even an ambitious domestic resource mobilization effort would contribute only about 5 percentage points of GDP toward funding this gap, according to the IMF.)

So what is limiting AfDB growth? Ironically, it may be too much regional ownership. Regional countries currently account for 60 percent of the AfDB shareholding but only four regional member countries are currently AfDF contributors. The countries of the region like their dominant role in AfDB shareholding. But as Nancy Birdsall explains in the “The Dilemma of the Africa Development Bank,” the AfDB’s governance arrangements are not conducive to raising money. They do not incentivize higher-income countries from outside the region to take on the responsibility and cost of becoming champions of the institution. Moreover, non-regional shareholders are generally skeptical of the institution’s operational effectiveness, making the World Bank a consistently more appealing choice for donors. Negotiations for a replenishment and a general capital increase are currently underway, but this tug of war is likely to continue to constrain the African Development Bank‘s size.  Even if the current GCI negotiations result in a doubling of AfDB's capital, annual financing from the AfDB group as a whole would grow to only about 1-3 percent of Africa's annual SDG financing gaps.

The case for a merger

To remain relevant and to grow, the AfDB must overcome this fundraising impasse. Reforming the AfDB’s financial structure and governance may be the most effective way to do so. A more consolidated shareholding structure with a handful of large regional and non-regional champions would likely better hold the institution accountable as well as better focus its strategy and work. A sensible approach with elements of appeal for both regional and nonregional shareholders would be a two-step process. Step one: Consolidate the capital of the whole AfDB Group. Step two: Rationalize the capital raising process so that it supports growth in overall institutional lending capacity in line with regional needs and institutional performance.

Financial consolidation: There are financial efficiency, policy, and administrative gains inherent to having a single entity with a consolidated balance sheet and harmonized fundraising and governance processes. This is especially true since the AfDB and AfDF already have largely overlapping clients and the majority of sub-Saharan African countries need some degree of concessional access. We believe that a tailored version of the Asian Development Bank/Fund merger is relevant for the AfDB.

Unified capital reviews: AfDF donors are now approached every three years for donations to the AfDF at the same time as the IDA replenishment negotiations. The result is often that the AfDF gets the short end of the stick. Moreover, there is no set schedule for general capital increases for the AfDB, so timing is ad hoc and not tied to any long-term strategy for capital growth in line with meeting the needs of the SDGs. Instead, we propose that the AfDB as one entity undergo regular resource reviews that would link the institution’s strategic objectives and performance to new financial commitments.

Let’s unpack these ideas one by one:

The financial case for consolidation

We know from the experience of the Asian Development Bank merger that a single balance sheet is more financially efficient than two separate balance sheets for the two entities. This is because of differences between the “hard” and “soft” loan windows’ financial structures. For one, the hard loan window is leveraged, meaning that it issues debt to finance its lending program.

In contrast, the soft loan window operates on a cash-in cash-out basis in which it receives grants from donors to finance its lending, requiring that it be recapitalized every few years by donors. Because soft loan window loans are grant-funded and eventually reflow to the institution, soft loan windows tend to have sizeable assets and often considerably more equity than the hard loan windows. For instance, in 2018, the AfDB’s equity (assets less liabilities) was around $9.9 billion, while the AfDF’s equity was more than double that at $24 billion (see table).

The guiding idea behind a merger is to combine the soft window’s unleveraged equity with that of the hard loan window, which allows the institution to increase its overall lending program with the same external capital because the merged entity can lend more against a larger capital base.

Our back-of-the-envelope calculations show that a merger could double the size of the institution’s lending program over the next five years sustained by the same level of donor contributions that the separate windows currently rely on. The financial model we are developing assumes $1.5 billion in donor grants annually (e.g., roughly equivalent to the current annual contribution levels set at the AfDF’s 14^th replenishment) alongside a doubling of callable capital (which is at no cost to donors). We estimate that this could sustain a doubling of the sovereign non-concessional, private sector, concessional, and grant program. Our model is conservative and maintains strong liquidity to offset the AfDF’s low credit quality loan book. And our projections do not assume new financial injections from the pending capital increase or replenishment.

More concessional finance

A merged balance sheet also allows for a more strategic allocation of concessional and grant resources. Under the current model, the AfDB provides non-concessional loans to middle-income countries, eligible low and lower middle-income countries (at low or moderate risk of debt distress) and the private sector across the region. The AfDF provides concessional loans and grants to low-income and lower middle-income countries only.

A merged AfDB would continue to provide the suite of financing terms. But the consolidation could create an additional source of concessional resources: net income from increased non-concessional loans and donor grants could be used to “buy-down” the terms of some of the market-financed debt to generate higher volumes of concessional finance than AfDF currently provides.

Finally, the one-balance-sheet approach would also enable the AfDB to better target concessionality to programs that need it most, based on whether the financing is being used for growth-promoting investment or to support consumption. And on the private sector side, a merged window could also allow the AfDB to deploy more blended financing.

Regular capital resource reviews

Because the development financing needs of the African region will likely rise for the foreseeable future, the merger does not mean that capital increases will be a thing of the past for the AfDB.

Instead, we propose a regular five-year resource review—similar to the EBRD’s—where shareholders and management assess the institution’s performance against well-defined targets and medium-term priorities to decide whether new capital is warranted.

If the shareholders decide that new capital is needed, they would agree on a target size for the institution and would make contributions based on its non-concessional, concessional, and grant financing needs.

The politics are hard, but not impossible

The politics of a merger would be hard and require regional and non-regional champions to overcome them. Deciding the shareholding structure of the new institution could take years. This is because the shareholding structures of the AfDF and AfDB are diametrically opposed. Non-regional shareholders would want the merged entity shareholding to reflect their contributions to the AfDF. For their part, regionals would likely not be happy with ceding some degree of control over the institution.

The challenge would be to convince both sides that gains exceed losses. Both regionals and non-regionals would gain from the unlocking of significant new lending capacity and less siloed decisions about how and when to use concessionality. And large historical AfDF contributors would gain from less frequent replenishment demands as well as tighter links between capital negotiations and institutional objectives and performance.

In addition, there would be a series of legal hurdles, including likely changes to the AfDB charter, that would need to be hammered out. A charter change would require an Act of Congress for the United States, something the Treasury Department would be reluctant to take on. (The memory of the 2010 IMF quota reform that took six years for the US Congress to authorize will likely weigh heavily on any decision to pursue any legislation related to the international financial institutions.)

Finally, before pursuing any major structural change to the AfDB, shareholders will need confidence that the institution has the capacity and wherewithal to undertake such profound reforms.

Our vision for the AfDB is not intended for the current round of general capital increase negotiations. Rather, it is a longer-term agenda. But we believe that it is a vision that shareholders should consider seriously—and could already start laying the groundwork for. As a first step, in parallel to the current general capital increase and replenishment negotiations, shareholders should commission an external study by an independent expert not chosen by AfDB management on the financial, legal, and administrative feasibility of a merger.

Stay tuned for a forthcoming policy paper that will flesh out the elements of this proposal.