Author: Rakan Aboneaaj

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.

Yesterday we sent the following memo to USAID Administrator Samantha Power, outlining opportunities for USAID to advance US development policy through better coordination with multilateral development banks. The text of the memo follows:

Background

The World Bank and other multilateral development banks (MDBs) are historically underutilized assets when it comes to USAID’s development objectives across a wide range of sectors and initiatives. Your high-level engagement with World Bank leadership acknowledges the promise of the bank as a powerful collaborator, but there are significant barriers at USAID to more effective partnership with the MDBs. This suboptimal relationship is due to governance choices made at the founding of the MDBs and enshrined in US law. As you know, the US Treasury Secretary is designated as the “governor” of each MDB and the Under Secretary of State as the “alternate governor,” empowering these two agencies with all decision-making authority related to US government participation in the MDBs. With no formal role in MDB governance, USAID has made do with ad hoc approaches to engagement, relying on participation in MDB trust funds, staff-level representation in some of the offices of the US executive directors at the MDBs, and pursuit of narrow statutory reporting requirements.

Other countries’ governance choices are instructive and suggest what may be lost in the absence of a more robust role for USAID. The United Kingdom designates the Foreign, Commonwealth & Development Office, the same office with responsibility for bilateral aid programs, with the MDB governor role. The UK finance minister plays the role of alternate governor. In practice, UK decision-making at the MDBs is much better integrated with decisions related to the bilateral aid program, and policy stances at the MDBs draw directly on a much deeper knowledge set compared to US policy led by the Treasury.

The choice of governance model deserves a deeper treatment of costs and benefits than we offer here. Instead, we start from the premise that any statutory change in US governance is highly unlikely. A modest effort to designate USAID as alternate governor at the regional MDBs a decade ago failed, despite general agreement among leading agencies. Governance changes would require enabling legislation, which has proved to be a barrier to reform.

Recognizing this, we offer instead a set of recommendations that USAID could implement largely within its own purview, or with a modest degree of cooperation from Treasury and State. With these changes, we believe USAID would be better positioned to benefit from the World Bank and other MDBs as development actors and, in turn, better shape US policy at the multilateral institutions by bringing to bear the experience and priorities of the world’s largest bilateral aid agency.

The MDBs, and the World Bank, in particular, bring unique value to a number of pressing issues in the form of large-scale financing, strong country relationships, and readily deployable technical assistance. Recent high-level meetings between USAID and MDB leadership covering subjects such as pandemic response, climate change, and food security suggest these MDB assets are increasingly prioritized within USAID. And the agency has a long history of establishing and contributing to MDB trust funds. But a more integrated and systematic approach to engagement could improve the complementarity of US development efforts supported through bilateral and multilateral channels and benefit US policy leadership in the MDBs.

Recommendations

Establish a clear home at USAID for collaboration with the MDBs:

We recommend USAID’s Bureau of Policy, Planning, and Learning (PPL) be the strategic home for agency engagement with the bank. PPL possesses the long-term, high-level perspective on US development policy to effectively shepherd complementary USAID collaboration with MDBs. USAID could also bring in relevant Regional Bureaus to provide policy input, especially with regard to the regional MDBs, such as the African Development Bank.

Improve incentives for USAID staff within the Office of the US Executive Director (ED) of the World Bank (IBRD):

At present, the US ED’s office at the World Bank is comprised of one senior advisor and four advisors detailed from the US Treasury Department (these five positions are paid for by the World Bank at a significantly higher pay scale, which helps to incentivize high performing Treasury staff to seek out the position). USAID, State, and Commerce each deploy advisors, but these positions are paid for by the respective agencies on the lower General Schedule pay band. A politically appointed Executive Director heads the office. There is also an Alternate Director slot reserved for a political appointee but, in practice, this position is rarely filled in tandem with the ED slot.

The Administrator should consider advocating for a World Bank-funded USAID Senior Advisor in the US ED’s office to better elevate USAID expertise on development policy and US global development goals. This would allow USAID to field a senior staff member who could work on a broader range of policy issues and have a direct line to the ED and Treasury. (In practice, the USAID advisor tends to focus on project transactions or discrete USAID initiatives.)

This will require working with the US Treasury to potentially grow USAID’s footprint, requiring Treasury to cede some portion of the office headcount currently reserved for department staff.

Work with Treasury counterparts to actively engage in negotiations of policy packages that accompany IDA replenishments:

The key mechanism for setting US policy objectives at the World Bank, particularly for lower-income countries, is the three-year IDA replenishment negotiations. Through these negotiations with other IDA donors, the US Treasury sets policy priorities on behalf of the US government across the full array of the bank’s activities. USAID to date has played no significant role in setting the US agenda or engaging in the negotiations. USAID should engage with Treasury counterparts in advance of replenishment negotiations, send a senior-level representative to negotiations (consistent with seniority levels at Treasury and State), and ultimately convey agency priority positions via the administrator directly to the Treasury Secretary.

Embed USAID staff in the MDBs to work across priority portfolios and sectors:

Limited knowledge of, and appreciation for, the MDBs’ range of development tools at the working level constrains agency efforts to collaborate with the institution. Such arrangements are fairly common but underutilized by the US government. The Centers for Disease Control and Prevention (CDC) embedded an advisor at the World Bank to work in the health unit in the aftermath of Ebola. The French government recently embedded a civil servant from the Direction générale du Trésor to work on the World Bank’s Sahel portfolio (a high priority for President Emmanuel Macron). USAID could consider a similar arrangement focused on vaccine access and deployment, food security, or with the bank’s fragile states unit.

Align USAID budgetary resources and tools with US policy objectives at the MDBs:

USAID often plays a leading role for the US government in the establishment and resourcing of trust funds at the World Bank and other MDBs. Yet, trust fund activity suffers from limited coordination with the US Treasury, and there appears to be no interagency process for determining the appropriate allocation of US government resources to the MDBs. For example, the US pledge to the IDA replenishment is determined by the Treasury, in consultation with the Office of Management and Budget, without any recognition or awareness of parallel initiatives to support World Bank trust funds by USAID. A more integrated budgeting process for MDB contributions could better evaluate the relative value of these contributions. In many cases, US policy could be better served by higher IDA pledges, supported by USAID resources, with “soft” earmarks delivering on USAID’s policy objectives. In general, the MDB’s core financing mechanisms (IDA, IBRD, etc.) will almost always represent better value for money than stand-alone trust funds.

Given the leverage potential of the MDBs, the US might also consider more innovative options for resourcing these institutions in service of common objectives. Both the Swedish and UK governments have recently provided portfolio guarantees to MDBs, enabling them to expand their lending portfolio to countries where the banks were nearing institutional lending limits (i.e., Ukraine). USAID could consider deploying MDB guarantees for either a list of countries or a portfolio of strategic interest (e.g., health, education).

Earlier this week, the Financial Times reported that the United States Treasury Department—the largest shareholder in the World Bank—delivered a letter protesting the Bank’s continued failure to meet the urgency of the biggest shared global challenges we currently face. The letter described “specific gaps and room for increasing climate ambition” and called for more “forceful and constructive leadership” from the Bank.

This isn’t a fringe position: at a time when governments seem able to agree on very little, the consensus around the Bank’s need to scale up its engagement on climate and other global public goods (GPGs) is striking. But “scaling up ambition” is vague, and there remains a great deal of work to do to pin down what it means in practice for the World Bank to rise to the GPG challenge, institutionally. It’s unclear what doing more on global challenges would imply for the Bank’s overall mission, products, country engagement, and financing model: these details need to be fleshed out. Whether the World Bank can evolve into a climate and GPG Bank will ultimately hinge not just on shareholders’ ability to arrive at a common vision but also their ability to agree on the details of a coherent plan and ambitious financing package to get there. In a new note, published today, we set out how it can get there.

As one of the only truly global institutions, the World Bank is uniquely positioned to be the world’s premier source of funding for GPGs. But despite its global coverage, the World Bank has never truly been oriented towards global challenges. Its mission has been defined primarily by individual developing country problems and priorities. This makes sense when the mission is only growth and poverty reduction domestically, but less when assessed against the progress required to avert catastrophic climate or health events.   

For that to change, the Bank’s financing for GPGs must become much larger and more effective, or it will fail to make a meaningful and measurable difference. The World Bank is already a major source of external finance for GPGs: between 2016-2021, it delivered $109 billion in climate finance, with annual commitments now exceeding $20 billion. But the scale of the financing requirements to address global public bads vastly exceeds the World Bank’s current financing capacity. And despite the headline figures, much of the GPG agenda has been deployed via trust funds and sometimes coordination with financial intermediary funds (FIFs), but these are small in size and ad hoc in relation to the Bank’s core agenda. (There is a small GPG fund financed by IDA reflows but amounts and functions to date have been too small to yet be significant.)

Disbursements from World Bank Recipient-Executed Trust Funds compared to IBRD and IDA, FY15-FY19 (in US billions)*

*Note: Chart includes overall data for recipient-executed trust funds, illustrating the relatively common use of trust funds across World Bank activities. 

Source: https://documents1.worldbank.org/curated/en/461611570786898020/pdf/Trust-Fund-Annual-Report-for-2018-2019.pdf

Addressing these weaknesses in the GPG response complements the existing country-based lending model but requires adjustments in approach and new tools that are more attractive to recipient countries. Country demand is at the heart of the World Bank’s existing model, and borrowing for GPG programs domestically often fits uneasily with restricted fiscal space and domestically determined policy priorities. And the calculus of a government’s demand for borrowing in this area is different depending on the salience of differing GPGs to different kinds of countries. A Bank that addresses GPGs effectively needs an offer that countries find attractive.

Alongside this, the Bank needs to directly confront trade-offs between development and GPG actions and take a clear stand on where it makes sense to use the marginal dollar raised to address one or the other. It may well be that in some countries, it is more efficient to use newly raised resources on development, until some absorption or returns bottleneck is reached, at which point spending shifts towards GPG priorities. Any credible GPG agenda will also need to be underwritten by a large grants funding stream, including for middle-income countries. Governments have little incentive to borrow to invest in programs where the benefits may not be directly captured the country, but they still must repay the loan. All of this points to an expansion, rather than just a reconfiguration of the Bank’s operations.

Such an expansion will mean more money but also new policies, pricing, and incentives, and models of financing for GPGs. There is—as the Treasury’s letter suggests—an urgent need for leadership, analysis, and directed financing of different kinds in policy and operations that can drive long-term, measurable progress towards global goals. To operationalize these approaches, the Bank will not only need to find a practical way to define what is (and what is not) a GPG and measure externalities associated with investments, but also to understand the possibilities for differential subsidization of the externalities across projects of different kinds as well as countries at different income levels. GPG solutions may require creative thinking and financing non-sovereigns in-country or at regional/global levels. Without new ideas, the Bank may run into the same kinds of difficulty it encountered in providing an early guarantee or lending to COVAX, the vaccine pillar of the Access to COVID-19 Tools Accelerator (ACT-A).

There is a clear hunger for the World Bank to be a leader on GPG issues, not only as a financier or vehicle. The Bank brings analytical capabilities, capacity building, and intellectual leadership to both country development and global challenges. The global system lacks an effective focal point in the fight against global public bads. Deploying the World Bank effectively, both as a financial and an intellectual leader, can fill that gap.

Keep an eye out for our upcoming work on MDBs for a global future.