Scope for more multilateral climate finance

Multilateral development banks are uniquely positioned to help governments make the necessary investments to achieve a carbon-neutral future. But to take advantage of their full potential, capital adequacy requirements that limit how much risk they can assume must be loosened

Frannie Leautier, Nancy Lee and Hans Peter Lankes 9 Dec 2022

With climate change already affecting the lives and livelihoods of millions of people around the world, the need for a coordinated global response has never been more urgent. But to mobilize the huge sums required to finance the investments we need to ensure a climate-resilient future, the world must establish institutions that can support large-scale green projects and programmes in developing countries. Fortunately, we already have such institutions in place: multilateral development banks (MDBs).

When multilateral lending institutions emerged in the aftermath of World War II, some questioned their financial sustainability and capacity to mobilize private capital for public projects. But the MDB model has proven to be dynamic and able to leverage governments’ capital contributions many times over. Given their access to cheap funds, highly rated MDBs can also offer long-term loans at relatively low cost, making them well-positioned to provide the scale of support needed to address the complex challenges of climate change.

But the MDB model has yet to achieve its full potential. A recent independent report commissioned by the G20 finds that multilateral lenders are constrained by capital adequacy requirements that place excessive limits on how much risk they can assume. As a result, capital is being underutilized at a time when the world needs it most. The report recommends a series of measures, including more accurate risk assessment, that would enable MDBs to use capital more efficiently and increase their lending capacity. Over time, according to the report, these reforms could increase MDBs’ lending capacity by hundreds of billions of dollars without hurting their AAA credit ratings.

While implementing these recommendations requires further analysis, MDBs already have a significant advantage over other lenders: preferred creditor treatment. This longstanding practice puts multilateral institutions ahead of other creditors in sovereign debt repayment. But private investors and credit-rating agencies are unsure how to quantify the value of this convention, because it is not written into bond and loan contracts. And the unavailability of consistent, detailed data about MDB credit performance heightens uncertainty about the effect of this mechanism on credit performance.

That is why the G20 panel commissioned an independent analysis to model the effect of preferred creditor treatment practice by comparing multilateral lenders’ credit performance to that of commercial lenders. The results were striking: based on publicly available data, borrowing countries are three to four times less likely to default on sovereign loans owed to multilateral institutions than they are on sovereign debt owed to commercial lenders, and MDBs’ expected credit losses were 14 times lower. MDBs’ existing capital adequacy frameworks, the panel concluded, underestimate the value of this preferential status, as do the methodologies of credit-rating agencies. More accurate risk weighting could free up substantial MDB capital, and greater transparency of MDB credit histories would also boost private sector interest in lending alongside MDBs.

MDBs’ other major advantage is their ability to “call on” contingent government commitments and convert them into paid-in capital if they are at risk of defaulting on their obligations to creditors. But that has never happened, and analyses reviewed by the G20 panel found that such capital calls are extremely unlikely. Recognizing that callable capital provides MDB creditors with additional financial security, rating agencies factor that into their bond ratings.

And yet most MDBs do not currently assign any value at all to their own callable capital. They should. Since such contingent commitments cover the extreme tail risk of default, multilateral lenders can safely adjust the risk parameters of their capital adequacy frameworks to create more headroom for increased lending. Doing so would not materially increase risk and would preserve their bonds’ sterling ratings.

MDBs can thus support and enhance development without forcing shareholding governments to change MDB statutes. In fact, the Inter-American Development Bank already reflects callable capital in its capital adequacy calculations.

MDBs can also innovate in ways that enhance their lending capacity. The G20 panel recommends that multilateral lenders use private insurance, securitization and third-party guarantees to free up space on their balance sheets. It also proposes offering new forms of hybrid non-voting capital to private and public actors, and for shareholders to extend temporary callable capital to support higher lending during crises.

These innovations are scalable and adaptable to each lender’s unique circumstances. Moreover, they do not require changes in multilateral institutions’ articles of agreement, shareholding structures or governance. They also have wider strategic benefits: they help crowd in the private sector, allow MDBs to focus on their comparative advantage in generating investments, and can be deployed in ways that accelerate the greening of MDB portfolios.

Similar measures have already been piloted in several institutions and must now be replicated across the MDB system. For the past few decades, multilateral lenders have excelled at prudent capital management. But by improving their capital efficiency, they could turn a successful model into a powerful tool for creating a sustainable, carbon-neutral world.

Frannie Léautier is CEO of SouthBridge Investment, Nancy Lee is a senior policy fellow at the Center for Global Development, and Hans Peter Lankes is a visiting professor in practice at the London School of Economics.

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