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Reforming capital adequacy at MDBs: How to prudently unlock more financial resources to face the world’s development challenges

Written by Arunma Oteh, René Karsenti, Elizabeth Nelson, Chris Humphrey

Hero image description: World Bank / IMF Annual Meetings, 2013. Photo: Simone D. McCourtie / World Bank (CC BY-NC-ND 2.0) Image credit:Simone D. McCourtie / World Bank Image license:CC BY-NC-ND 2.0

In July, the panel of the Independent Review of Multilateral Development Banks’ (MDBs’) Capital Adequacy Frameworks submitted its report to G20 finance ministers. The report centres on five recommendations that, in the view of the independent panel (of which the authors were all members), could unlock several hundred billion dollars in additional lending headroom, without posing a threat to MDB financial stability or their AAA credit rating.

While the capital adequacy of MDBs may be technical, it is central to the ability of this crucial set of international institutions to respond to short-term crises and longer-term development challenges, particularly ending poverty, addressing climate change and promoting planetary sustainability .

MDBs get most of the funding they need to operate by borrowing on international bond markets, unlike most bilateral and UN agencies, which rely on direct funding from (increasingly constrained) government budgets. This is the key to the financial power of MDBs. With a small amount of shareholder capital and a strong financial track record, MDBs can borrow substantial medium- and long-term resources from bond investors at excellent financial terms, which they on-lend for development projects. MDB financing is usually coupled with technical support to ensure quality, sustainability and development impact.

How much capital is ‘adequate’ for an MDB?

The bond investors who supply most MDB resources want to be sure that MDBs can repay their bonds. So, like all banks, MDBs must back up their loan portfolios with an ‘adequate’ amount of their own shareholder capital to meet their financial obligations even if some borrowers do not pay them back.

How much capital is adequate for an MDB? The financial risks posed by MDB operations are very different from those of commercial banks because of their official standing and development mandate, so they cannot simply apply commercial bank capital adequacy standards such as the Basel III guidelines.

MDB finance teams and the three main credit rating agencies take different approaches to MDB capital adequacy. This makes it difficult for shareholder governments to compare across institutions or, in the end, know how much an MDB can prudently lend based on its capital.

In response, the G20 established the independent review to evaluate MDB capital adequacy. Based on the evidence, the review panel concluded that government shareholders, MDB management and credit rating agencies have overestimated the financial risks facing MDBs by underestimating their unique strengths. The panel proposes several measures to update capital adequacy policies and make more efficient use of MDB capital.

We consider the recommendations to be reasonable and informed, and take into account the importance of maintaining the strength of MDBs given their crucial global role. The recommendations benefited from extensive MDB data we gathered, multiple workshops we held with MDB management, credit rating agencies and other stakeholders and statistical studies that we commissioned. The 14-member panel included, among others, two former MDB treasurers, one former MDB chief risk officer, one former MDB auditor general and the current head of risk management of the Bank for International Settlements. These are people with a deep understanding of MDBs and financial markets, and all of the report's recommendations were agreed unanimously.

Two central issues underpinning the report recommendations are preferred creditor treatment and callable capital. In the panel’s collective view, these represent very significant financial strengths that do not appear to be sufficiently reflected in MDB internal capital adequacy policies or in credit rating agency methodologies for rating MDBs. Doing so would create substantial additional lending headroom at the major MDBs. The panel recommends that MDBs and their shareholders work collectively on these critical recommendations, while implementation will need to take place at level of individual MDBs.

Preferred creditor treatment

One of the most notable historical observations about MDBs is that the loans they make to borrower governments are always repaid. On the rare occasions when borrower governments do fall behind on repaying MDB loans, they invariably eventually repay their obligations in full. MDBs have only ever not been repaid as part of international debt relief initiatives, where any losses were born by donors and not the MDBs themselves.

One of the main reasons that MDBs have a very strong loan repayment track record is their ‘preferred creditor treatment’ (PCT). As a consequence of PCT, borrowers prioritise repaying MDB loans over others even when they are facing financial difficulties because they view MDBs very differently from commercial lenders. MDBs are public institutions that do not seek to maximise profit. They are cooperatives in which borrower member countries are themselves part-owners and maintain long-term relationships with borrowers, offering regular, sizeable support for development investments. In many cases, MDBs have cross-default practices that further encourage borrowers to prioritise payments to MDBs over other creditors. They can be relied upon to work with a country even in a crisis when financial markets are difficult to access, offering affordable loans and a wide range of technical support.

MDB internal capital adequacy frameworks and rating agency methodologies recognise the value of PCT, but not nearly to the extent that the evidence justifies. A study undertaken for the panel, using MDBs’ own data, showed that expected credit losses on public sector loans from 1991 to 2020 were 15 times lower than losses faced by commercial lenders (banks and bond investors) to the same borrowers. The numbers for MDB loans to private sector borrowers are not as strong but still substantially better than commercial lenders. The panel plans to release this study as soon as agreement is reached related to data confidentiality.

In the panel’s view, MDBs and credit rating agencies do not consistently nor sufficiently reflect PCT in how they model MDB portfolio risk parameters (especially for loans to public sector borrowers). Adjusting the parameters based on the historical evidence, as the report’s first recommendation proposes, would generate substantial additional lending headroom across the MDBs.

Callable capital

A second key factor that could increase the capacity of the MDBs is callable capital. This is a unique type of guarantee committed by shareholders to be called for the sole purpose of paying debt obligations to bond holders in the event of an extreme shock that significantly impacts MDB finances. Callable capital amounts to US$1.2 trillion across the 15 MDBs within the scope of the review, but it has never even come close to being called upon by any MDB, even in the most severe global and regional crisis experienced since the founding of the World Bank, almost eight decades ago.

Credit rating agencies give some uplift to MDB ratings as a result of the additional financial security provided by callable capital, although the way and degree they do so differs and, in the panel’s view, could be improved. However, most MDBs themselves calibrate their capital adequacy frameworks as if their callable capital did not exist. MDBs and their shareholders should be encouraged to recognise a portion of the additional financial security given by callable capital and to adjust the risk appetite and parameters within their capital adequacy framework, as described in Recommendation 2 of the report.

The panel is of the view that doing so would not materially increase the risks of callable capital being called. A study commissioned by the panel showed that, even using conservative assumptions, the circumstances that could lead to an actual capital call are extraordinarily unlikely – in the range of a ten standard deviation event. Recognising callable capital’s additional risk-taking capacity benefits does not increase the risk profiles of MDB portfolios. The increased portfolio size itself is highly unlikely to lead to a change in the minute probability of a massive, catastrophic wave of defaults many times greater than has ever occurred that would result in a need to make a capital call.

Given the remote risk of a capital call, shareholder governments would not need to change the way they treat it in their budgetary frameworks. Most frameworks only require provisioning for contingent liabilities that have a likelihood of being triggered at a level far greater than callable capital (a 50% likelihood in the case of EU countries, for example).

Nor would it be necessary to change the articles of agreement of any MDB, which stipulate that callable capital can only be used to pay off MDB financial obligations. The panel recommendation does not change that in any way – it simply proposes that MDBs recognise that this unique guarantee exists in defining their risk appetite and capital model risk parameters.

Callable capital is designed to cover the very extreme ‘tail risk’ of probability that an MDB faces a massive financial collapse. Knowing that the tail risk is protected by this guarantee, MDBs can safely adjust their risk threshold in the capital adequacy frameworks to increase available lending headroom, in line with the approach taken by rating agencies. This can be prudently done by taking into account each MDB’s loan portfolio, callable capital structure and development goals.

Callable capital is an innovative guarantee instrument created by international treaty that has been in existence since the World Bank was founded in 1944. The panel proposes that MDBs put much more emphasis on the benefits of this powerful tool, as rating agencies already do. Doing so would not only create substantially more lending headroom right now at no additional cost, it would also multiply the impact of any future MDB capital increases.

Balance sheet innovations, rating agency methodologies and benchmarking

Adjusting risk appetite through recognition of callable capital and clear reflection of PCT in capital adequacy parameters are key components of the first two recommendations in the panel’s July 2022 report, which address the core of MDB capital adequacy and have the most potential for generating substantial lending headroom. Three other recommendations build on and support the first two, providing additional tools and strengthening the enabling conditions for efficiently and prudently maximising MDB capital deployment within a AAA rating target.

The third recommendation outlines a series of innovations like risk transfer mechanisms, non-voting capital and shareholder guarantees that can shift risk off MDB portfolios to willing counterparties or find other sources of capital within existing governance arrangements. Many have already been successfully piloted; others are being developed. All have the potential to be deployed more systematically as part of a ‘toolkit’ for each MDB to flexibly manage portfolio risk, crisis scenarios and credit rating agency criteria. The panel recommends that MDBs cooperate more in the development of these tools and share the cost associated with this work to allow more MDBs to leverage the ‘toolkit’ when needed.

Even more lending headroom could be generated if rating agencies refined their methodologies to better reflect very low MDB credit risk, addressed in the fourth recommendation. Widely divergent MDB rating methodologies pull the MDBs in different directions to maintain their AAA rating with all three agencies. A study commissioned by the panel found that a stylised MDB could nearly triple its loan portfolio within a AAA parameter by one rating agency, but could only increase its portfolio by 34% under another agency’s methodology and 11% by the third and maintain its AAA rating. MDBs and shareholders need to better coordinate engagement with rating agencies to ensure an appropriate understanding of their financial strength and shareholder support.

The fifth and final set of recommendations highlights that greater transparency, financial governance expertise and benchmarking will better position shareholders to take informed decisions on MDB capacity and capital needs. This G20 review was a first step toward a more coordinated, evidence-based approach to evaluating capital adequacy across MDBs. This should continue on a regular basis, possibly through a more robust institutional platform involving several MDBs and external financial experts. Such a platform – preferably building on the under-utilised Global Emerging Markets (GEMs) database of MDB loan performance – could undertake regular benchmarking, commission relevant studies, inform shareholders and help engage with rating agencies. The wider availability of GEMs statistics would help educate investors and encourage greater private sector investment alongside MDBs.

Updating capital adequacy is part of a broader MDB reform agenda

The recommendations proposed by the expert panel address issues of MDB capital adequacy and lending headroom with a view to enabling them to do more to address the enormous development challenges that our world faces. While capital adequacy is only part of that broader agenda, it is at the very core of what makes MDBs so powerful. They mobilise international bond market resources and channel them to global public goods. It is an excellent proven model, and has worked for nearly eight decades. Making the most of such an impactful model is essential to positioning MDBs to help tackle the current and future challenges to people and planet. The G20 panel report does not have all the answers, but it has begun a conversation on how to best do that.