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Why Should You Care About MDB Capital Efficiency?

At the July G20 meeting of finance ministers and central bank governors, a panel of experts (of which I was one) presented their report on the capital adequacy of the multilateral development banks (MDBs). The G20 had commissioned the study to get an independent view of whether shareholder capital is being used efficiently, that is, to support as much development lending as possible without excessive leverage and while maintaining AAA ratings for those MDBs that have them. G20 ministers welcomed the report and decided to publish it.

The report necessarily is technical in nature. Those outside the narrow world of MDB risk managers and treasuries, credit rating agencies, and MDB executive board members may wonder why they should care about it. The answer quite simply is that hundreds of billions of dollars are at stake. As with any bank, small changes in the capital available to MDBs make large differences in lending capacity and volumes.

One hardly need dwell on the case for more MDB lending, which becomes more urgent by the day as global and regional shocks—driven by conflict, climate change, and pandemic disease—multiply and persist. MDBs and the IMF have always had countercyclical roles in crises, but, in this century, developing countries have become increasingly vulnerable to external shocks, as distinct from their own internal policy failures. Their policies certainly still matter, but even the right policies cannot insulate them from the deep and lasting damage.

Perhaps more than ever before, the need is global. Developing countries in all regions need help in weathering these storms, especially finance that does not drive them into unsustainable debt. No institutions are better suited, with a better array of financial and nonfinancial tools, than MDBs to help them ease suffering for the most vulnerable, build resilience to future shocks, and invest more in public goods that carry regional and global benefits. The challenge to respond at scale is shared by all MDBs; it is not specific to one region or a few MDBs, as often in the past.

For commercial banks, capital efficiency is built into the profit imperative and markets. Private shareholders will not long tolerate idle or underutilized capital. And on the prudential side, regulators set rules for leverage and risk management and oversee compliance.

MDBs are subject to neither the profit maximization goal nor regulators. They and their mission are unique. They must be financially sustainable, but also take risks to maximize development impact. As the report notes, that raises important questions and uncertainties about capital adequacy. Decisions about how much capital to hold against lending must take accurate account of the risks but also of MDBs’ “preferred creditor status” (PCS), which places them ahead of other creditors in sovereign loan repayments.

Fortunately, given the length of time MDBs have been in operation, there is an empirical basis to judge these risks and the value of PCS. MDBs have extensive track records—across time, countries, regions, and sectors. In fact, they have collectively constructed a database called Global Emerging Markets (GEMs), which contains transaction-level data for assessing credit performance and risk for loans from MDBs and development finance institutions to the public and private sectors. But few outside the MDBs have access to these data despite its clear market-making potential. And credit rating agencies may have access but generally do not deploy granular data from GEMs in their risk weighting.

Credit rating agency methodologies, which differ greatly from each other, are critical here. Because MDBs are not regulated, the three main credit rating agencies (CRAs) play an outsize role in shaping MDB capital management, especially as MDBs are obliged to work toward satisfying all of the diverse CRA criteria if they are to maintain AAA credit ratings from all three agencies.

One other important uncertainty stems from the form of shareholder capital subscriptions. Capital from governments is partly paid-in (as cash) to the institutions, but a substantial amount is in the form of contingent commitments referred to as callable capital. Such capital can be “called”, that is, converted into paid-in capital, if the MDB is at risk of default on its own obligations, which has never happened. Governments are subject to political uncertainty, and there are reasonable questions about whether all shareholders would furnish paid-in capital promptly in the extremely unlikely event that a call should be necessary.

In these circumstances, shareholders, responsible for efficient as well as prudent use of capital, have long worried that capital management in MDBs has settled into a suboptimal equilibrium, with too much underutilized capital and too-tight constraints on lending. This concern prompted the central question posed by the G20 to the panel: are there financially sound ways to manage capital that expand lending capacity without jeopardizing AAA credit ratings?

The panel’s answer to that question, after careful information gathering, analysis, and extensive consultations with a range of stakeholders, is a clear yes. It recommended specific actions that, taken together, offer a roadmap to achieve that goal. The recommendations are broadly applicable, scalable, adaptable to the requirements of individual MDBs, and mutually reinforcing. They offer practical ideas for freeing up, or mobilizing new forms of, capital, including countercyclical buffers, to help MDBs manage risk going forward in these uncertain times. If MDBs and their boards move forward together and share learning and evidence, both the potential risks and costs can be minimized.

The report recommends that MDBs:

  • Define risk tolerance limits first and foremost in line with shareholder preferences, which include, but are not limited to, targets for institutional ratings;
  • Use a prudent share of callable capital in assessments of capital adequacy;
  • Use proven approaches for offloading risk to free up capital for more lending, including climate finance;
  • Offer new forms of non-voting capital, including hybrid capital, to governments and interested private investors;
  • Enhance dialogue with CRAs for mutual understanding and benefit;
  • Provide technical support for shareholder oversight of capital adequacy and conduct regular, evidence-based capital reviews;
  • Share disaggregated statistics on credit performance (appropriately anonymized for private transactions) to improve the accuracy of risk assessments by CRAs and private investors.

These measures may seem common sense to many readers. But it would be a mistake to underestimate the governance, bureaucratic, and political obstacles to change. Some MDB leaders, interested in future general capital increases from shareholders, may perceive greater capital efficiency and the associated expanded lending capacity as weakening their case. Shareholders must be clear that the logic works the other way around: more productive use of existing capital strengthens the case for more capital.

Fundamentally, G20 and other shareholders must lead with consistent and resolute support, attention, and oversight. Success is unlikely unless a critical mass of borrowing and non-borrowing countries step forward as champions. Many of us are also waiting to see if a few far-sighted MDB leaders will seize this opportunity to make the proven MDB financial model even more powerful.

Disclaimer

CGD blog posts reflect the views of the authors, drawing on prior research and experience in their areas of expertise. CGD is a nonpartisan, independent organization and does not take institutional positions.