This piece originally appeared in the online magazine, Development Finance.
Amid much discussion of SDG finance gaps, development finance institutions (DFIs), both bilateral and multilateral, are in the spotlight as the most important publicly funded instruments for mobilising private capital.
Yet, there is a surprising lack of clarity on what we can and should expect from DFIs, beyond broad goals of profitability and development impact. The following proposes some operational principles that help set standards for DFI success. No existing institution deploys them all, though many are moving in the right direction. The point of the list is to highlight that important changes are needed in DFIs’ business models. With such changes, I believe a strong case can be made to expand their capital and operations.
1. Prioritise private finance mobilisation as much as institutional returns
DFIs are held accountable by their shareholders first and foremost for the volume of their own business and returns. Returns can trump mobilisation ratios (dollars of private finance mobilised per dollar DFIs commit), leading DFIs to focus on lending rather than more catalytic but less profitable tools, such as guarantees. Without ratios much higher than those current achieved—US$1.5 to US$1 for the MDBs according to one report—DFIs will fail to contribute meaningfully to filling SDG finance gaps.
2. Focus on capital market gaps
To catalyse private finance that would not otherwise flow, DFIs must help bridge gaps in capital markets. Yet DFIs are often criticised for occupying the same space as private investors. They, like private investors, limit their exposure to areas of capital scarcity like early stage finance (for firms and for infrastructure projects) and high risk project tranches—e.g. junior equity. To support increased DFI operations in these riskier areas, I have proposed elsewhere the creation of off-balance sheet special purpose vehicles to help DFIs manage such risks while maintaining triple A ratings on their core balance sheets.
3. Aim for market impact
To make or build markets, DFIs need to choose projects specifically for their likely impact on the behaviour of market actors, market infrastructure, and the management of first mover costs and risks (in ways that do not discourage other market entrants). In allocating grants and other blended finance tools, priority should be given to non-firm-specific obstacles that affect actors across the market: information or skill gaps, collective action problems, or the need for new business models that work in low income and difficult environments.
4. Share performance track records
DFIs have long financial track records that show respectable financial returns in the aggregate. But, with some exceptions, they do not share performance at the project level with the private sector. They therefore miss the opportunity to use the power of their own data to signal markets on profitable investment opportunities, to price risk more accurately, and to avoid unnecessary public subsidies.
5. Create internal capacity to pilot innovations
Conventional wisdom asserts that the problem for DFIs is largely the scarcity of bankable projects, suggesting a fixed supply. It is more accurate to view project supply as partially endogenous (originating from within) to the operations of the DFI itself. The capacity to pilot innovative business models or new goods and services, adapt them to market feedback, and take them to commercial viability expands pipelines for DFIs and other market actors.
6. Practice collaboration with other DFIs
DFIs compete more than collaborate—rational behaviour in a world where their capital and their capital increases are dependent on their business volume. Shareholders need to change this dynamic by judging DFI performance more by the power of the partnerships they build, the scale they achieve, their strengthened risk management through sharing exposure, and their combined mobilisation of private finance.
7. Build compacts with investment climate reforms that support project viability
For MDBs especially, their unique comparative advantage is their ability to support policy and institutional reforms (PIRs) as well as finance projects. They would do well to consider the Millennium Challenge Corporation compact model which brings sectoral PIRs and project discussions together in the compact negotiation between the MCC and the partner country. The result is greater country ownership and greater synergies between policy and projects.
8. Integrate gender into every project
If interventions that help women access project benefits are not explicitly incorporated in project design, women often gain less than men. For example, giving women access to infrastructure construction jobs, introducing gender neutral SME credit assessments, including women in the management of farmer cooperatives all create gains for women that do not have to come at men’s expense. There is no rationale for failing to structure projects in ways that make everyone better off.
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.