Can DFIs Be First Responders in a Crisis?

You might find this question—can DFIs be first responders—odd. After all, since the outbreak of the COVID-19 pandemic, the development finance institutions (DFIs), which include the private finance arms of the multilateral development banks (MDBs) and the bilateral development banks, have been busy announcing financial goals for crisis response, and offering reassurances of proactive stances. But it is important to recall at this moment that their financial models are not well suited for the purpose of crisis response. In this blog we explore their challenges and suggest how they can stretch and deploy their capital effectively at this moment of global crisis.

Development finance institutions and crises

It is during crises that the logical tensions of the DFI model are most exposed. We expect DFIs to offer finance on terms not available from the private sector. This is how we can tell they are “additional.” At the same time, we want DFI credit decisions and finance terms to be “commercial” or “market-based.”

But right now we expect DFIs to lend countercyclically and at scale into a global recession and pandemic—that is, they are being asked to significantly boost lending at a moment of maximum risk and uncertainty. In short, we are asking them to take outsize risks while avoiding effects on balance sheets and ratings.

Shareholders have long been unclear about how they want these institutions to approach trade-offs. This ambiguity is awkward in normal times, but it is highly costly in a crisis when basic questions need to be answered quickly. Some of the key questions facing DFIs are:

• Should DFIs be among the first responders or hold most of their financial firepower for the recovery stage?

• Should shareholders allocate more public resources for blended finance, or for lending to embattled governments? Do DFIs need more capital to respond to the crisis or do they need to stretch their existing capital?

• Should DFIs continue to concentrate on middle-income countries (MICs) where private capital markets are more developed and most of their clients are, or should they double down on efforts to ramp up in low-income countries (LICs) where financing constraints are most binding?

• Should the DFI role be to restart capital flows generally, e.g., trade finance, or target where the finance gaps are greatest, such as long-term financing for infrastructure, finance that reaches the poor and vulnerable, or launching new local financial markets and products?

When the need is so great, the temptation is to answer all these “either/or” questions by saying, “let’s do both.” But DFIs cannot be all things to all stakeholders, especially in a world of shrinking public revenues and exploding public spending needs.

The good news on capital

Partly because of recent MDB capital increases, but also very conservative capital adequacy strategies, multilateral DFIs are in a better position now than they were in the global financial crisis. They hold more equity relative to loans than commercial institutions do. For the DFIs that only or mostly finance the private sector—the EBRD, the IFC, and IDB Invest—equity/loan ratios are two to six times higher than their commercial counterparts.

For those banks that combine their sovereign and private operations on the same balance sheet—EBRD, AfDB, AsDB—equity in these ratios includes only paid-in capital and accumulated earnings, not callable capital. Callable capital is a contingent commitment by shareholders to provide the capital if the institution itself is at risk of default, which has never happened, even during the global financial crisis. It accounts for an average of 89 percent of the total capital that shareholders commit to these three institutions. But, as a matter of policy, risk-averse finance departments in these institutions do not include it in calculating prudential lending limits.

This unique MDB capital model is efficient. It avoids having shareholder legislatures appropriate money that is extremely unlikely to be needed. Even now, there are no indications that any call for this capital is forthcoming. But its presence as an insurance policy gives these institutions the flexibility and scope for major increases in lending while still maintaining equity/loan ratios above those of their commercial bank counterparts. The message from shareholders to these institutions should be: The rainy day has arrived, and it is time deploy the financial space available.

More targeted capital?

To be fair, if DFIs do in fact lean in a big way into crisis response, they will be managing increased risk from every side: counterparty, credit, currency, macroeconomic, debt default, and political risks. And, as liquidity problems turn into solvency problems, the instrument mix will likely have to include more subordinated and other products that eat up more institutional capital—e.g., equity, quasi-equity, local currency lending. Part of the increased risk can be addressed through loan pricing. But if the DFIs are to be first movers, they will have to bear part of the costs and risks themselves.

So if they are doing their job, the case for additional capital for MDBs that do private finance could well emerge over time. Shareholders will have a choice. They could:

• Reserve any additional capital only for lending to governments,

• Put more capital into the existing risk-averse DFI financial model, or

• Create another financial structure to add to the model for the specific purpose of absorbing additional risk and increasing impact.

I advocate the third option—an off-balance sheet vehicle, purpose-built to take on more risk. We have proposed elsewhere the Stretch Fund, which could be accessed by multiple MDBs and even bilateral DFIs. Its characteristics would be quite different from, but complementary to, existing institutions:

• Its financial target would be to preserve its capital rather than risk-adjusted market returns. It would not lose money and would not be a grant-making donor.

• It would specialize in subordinated products, rather than the senior lending that dominates DFI portfolios.

• It would be capitalized by governments and by private philanthropic investors that share a greater risk tolerance for the sake of greater development impact.

• Unlike the IDA Private Sector Window, it would operate in both MICs and LICs. And it would not only be a passive project taker from the IFC. It would also have the capacity to be a proactive project originator with a more risk tolerant culture and governance structure and a different financial product skill mix.

Such an innovation to the DFI financial model is needed in normal times for greater development impact and greater mobilization of private finance. In times of crisis and heightened risk, the case only becomes more pressing.

Bringing governments and entrepreneurs together for crisis response

Finally, beyond questions of capital adequacy and allocation, there is a critical crisis role that MDBs can play because they engage and finance both governments and private businesses. That capacity puts them in a strong position to address the one of the most pressing crisis challenges: getting services and income support to the most vulnerable.

Especially in LICs and LMICs, public sectors cannot execute the scale of support that is needed to offset income declines. They often have little capacity to reach those in the informal sector and in rural or remote locations. This is a time to use innovative private business models and technologies to cut the costs and improve delivery of services, social transfers, and finance for small businesses and farmers in order to reduce crisis effects on the most vulnerable.

MDBs can use their public arms to help governments fund such programs and their private arms to help identify and finance the right private firms and financial institutions as partners. Together they could do much to stretch scarce public resources and reach those who would otherwise be subject to catastrophic income and welfare losses. Bringing the two arms together should also reduce risks to the MDBs themselves by strengthening the performance of their clients—countries, households, businesses, and financial institutions.

Mobile payments providers and lenders, microfinance institutions with thousands of clients in informal sectors and rural areas, e-commerce companies, and drone operators can help solve problems of access and reach. Governments could, for example, distribute small grants through mobile payers or microfinance institutions, or pay for forgiveness or rescheduling of existing loans. Or governments could use competitive challenges that offer payments to firms that can deliver critical health and other services to vulnerable or remote populations.

The MDBs are unique. No other financial institutions have the array of tools available to them: economic, financial, and sectoral analysis, and cross-country knowledge; budget lending; technical assistance; policy and institutional support; project development funds; public and private project finance; and risk-sharing tools. In this unique crisis, all are needed. MDBs have the opportunity and obligation to mobilize this toolkit to help countries act much more effectively, faster, and with greater scale than they could on their own.