Could multilateral banks be lending an extra $1 trillion?

6 May 2016

It seems that the World Bank and other major multilateral development banks (MDBs) could collectively lend US$1 trillion more than they are currently—a 72% increase on their 2014 portfolios—with no threat to their AAA bond rating.

Who knew?

Standard and Poor’s, apparently. The credit rating firm released a briefing to that effect on April 12th. How can a briefing note by a private company potentially have such a huge impact on the financial capacity of the world’s most important development agencies?

The short answer is that, as one MDB finance official put it me bluntly, ‘S&P has become our regulator.’

Unlike almost all other financial institutions, MDBs have no regulators, or even an industry oversight body like the Basel Committee on Banking Supervision. That didn’t matter back in the Bretton Woods-Cold War decades, when U.S. government backing was basically good enough for MDB bond buyers. But in an era of dizzying financial complexity, this state of affairs leads to uncertainty about the financial strength of MDBs, leading to more conservative financial policies that limit their developmental impact.

As it stands now, there’s no agreement on how to evaluate MDB capital adequacy. Does measuring return on equity make sense in evaluating a non-profit development bank? How to account for preferred credit status and the inherently concentrated nature of MDB loan portfolios? What about callable capital—a guarantee put up by MDB member governments totalling hundreds of billions of dollars? No one has a clear answer.

MDBs tap capital markets rather than government budgets for most of their operating resources—a key reason for the enduringly popularity of this organisational model. The main division of the World Bank, for example, lent US$628 billion and amassed US$27.5 billion in reserves between 1945 and 2015, with a total of only US$15.2 billion in paid-in shareholder capital—not bad financial performance for a development agency.

But with no roadmap on how to evaluate MDBs, the big three agencies of S&P, Moody’s and Fitch have all come up with dramatically different methodologies. S&P’s new methodology released in 2012 is particularly conservative, and creates incentives for MDBs to restrict lending to countries facing economic difficulties—exactly when countries most need help from MDBs.

As an operational vice-president in one of the major MDBs told me recently, ‘You cannot understate the impact that this methodology has had on our operations...Formerly we assigned our resources strictly based on need and absorption capacity. But bit by bit the S&P methodology has become the main driver of our allocation decisions.’

These restrictions are running up against a growing consensus in the G20 that the MDBs should take the lead in a major infrastructure push across the world to achieve the Sustainable Development Goals.

So S&P is feeling the pressure to ease up. The April 12th press release is a result of that, as several senior MDB financial officials told me in recent days. But informal government pressure on a rating agency isn’t the best approach to loosen the conservatism that dominates MDB financial policy. MDBs are too important—amore systematic solution is needed.

One option is for a credible external agency—like the Basel Committee—to come up with an independent methodology for evaluating MDB finances, which could serve as a reference point for rating agencies. MDBs won’t like the idea of external oversight, but it is bound to be better than the current situation, where rating agencies use a number of criteria that frankly make little sense to arrive at their MDB ratings.

A second option is for MDBs to standardise financial and organisation reporting on their activities, making it easier to design clear criteria to evaluate them. MDBs are already moving slowly in this direction, with working groups among risk officers and efforts like Common Performance Assessment System (COMPAS) to generate a small set of common reporting indicators. These efforts should be formalised and expanded, with the support of MDB shareholders.

Rating agencies must do their job, but greater coordination and standardisation among MDBs as well as an evaluation methodology by a credible external agency will make the process more transparent. This will give MDBs and bond investors greater certainty, freeing resources for the investments in sustainable infrastructure and human capital our planet badly needs.