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Development finance institutions grapple with their growing role (Devex)

March 19, 2019

From the article:

Small agencies that work alone, siloed off from the rest of a country’s development work: That’s how development finance institutions might have been described just a decade ago. But DFIs have gained prominence as the role of the private sector has been accepted and because their work can be put in direct service of meeting the Sustainable Development Goals.

As the paradigm shifted from a focus on social service support and grant-based official development assistance to one more driven by private sector development, countries have turned to development finance institutions to provide solutions to help create jobs, spur economic development, and reduce poverty. As a result, the number of institutions has proliferated.

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Taking risks

In the past several years, a number of DFIs moved to invest more in least developed or low-income countries.

Deals in LDCs are difficult and complex. They require taking more financial risk and more effort and creativity, said Colin Buckley, chief operating officer at CDC.

Historically, DFIs have been hesitant to invest in fragile states and risky settings where the investment had less than an 80 percent probability of success, even if it had the capacity for transformative impact, Buckley said.

“One thing DFIs need to be more comfortable doing is rolling the dice for transformative impact,” he said.

DFIs will not, and cannot, solely invest in the poorest, riskiest places. In an effort to remain profitable and balance their portfolios, they will continue to make some investments that are deemed safer, even as they look to invest more in low-income countries.

But some experts believe that DFIs should be taking more risk and doing more to crowd capital into higher risk markets where private finance is especially scarce.  

“Some DFIs — I’d pick on IFC [the International Finance Corp.] for sure here — are mostly not in high-risk markets and not very engaged in high-risk sectors and are mostly doing safe projects,” said Todd Moss, the executive director at the Energy for Growth Hub, a spin-off from the Center for Global Development, where he is also a visiting fellow.

Part of the problem has to do with incentives: At some DFIs, investment teams are rewarded based on the amount of money invested, rather than on where it is invested or what its impact will be. There is also often pressure on the financial side, especially for DFIs that operate like commercial banks and are trying to maintain AA or AAA credit ratings.

“The scale and risk issues mean for these agencies to succeed, they need to create internal incentives for people to take risk and subsidize upfront costs,” Moss said.

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As a result, in some industries, DFIs appear to be preventing a natural progression to more commercial capital over time, keeping them locked in as sectors dependent on concessional financing, he said.

Not all DFIs are investing in that way, the investor noted. He pointed to a recent Overseas Private Investment Corp. deal where OPIC made part of its investment junior debt, a move that would allow the fund to raise more commercial sources of capital, which would need to be senior debt.

“I dont think they’re chasing out private capital very often. The bigger problem is sometimes crowding in other DFIs rather than truly private capital,” Moss said, adding that it could be an issue of immature markets that would change over time.

Some, including Andreasen, said that they don’t see competition as a problem, and instead often see DFIs working together. About one-third of individual investments that the European bilateral DFIs make are done alongside other European DFIs, he said.

“It’s fine to have debate and scrutiny in this respect, but I don’t see a lot of specific evidence,” Andreasen said.

One place DFIs are playing a critical role, and are working together, is in financing local banks in Africa in the wake of restrictive regulations around risk that have led many commercial banks to pull out, he said.

Buckley said DFIs haven’t been very good at coordination with one another or with aid agencies. Often, transformative investments need regulatory or institutional reform — and that is where DFIs should work more closely with aid agencies to address some of those challenges.

“I think people should demand more cooperation as DFIs grow in prominence and capital,” Buckley said.

Transparency and measurement

As more funds are funneled through DFI investment mechanisms, demand is growing for better measurement and improved transparency.

“As public agencies, they should be as transparent as possible — they don’t need to release every detail of every project, but they should release information about activities ... as maximally as possible,” Moss said.

A DFI should release all information unless there is a commercial reason not to, he said. It should be transparent about systems for evaluating development impact during and after it makes investments, and the data should be made available in easily accessible formats.

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Photo of Todd Moss
Visiting Fellow