Private Finance Is Coming off the Sidelines on MDB Reform
How multilateral development banks and private finance can unlock funds for those who need it most.
What are MDBs, and why are they being reformed?
Multilateral development banks (MDBs) are financial institutions that provide financial support and technical guidance to member countries to facilitate economic growth and lower poverty levels. MDBs require fundamental reform to tackle the pressing dual challenge of climate change and development. The MDB reform agenda involves improving MDB governance structures, objectives and targets, operational effectiveness, and creating new financial instruments to mobilize public and private capital for climate investments. Such discussions can be traced back as early as 2001 in the G7’s Genova communiqué, however, MDB reform efforts have recently gained steam, with MDB shareholders led by Barbados, France, and the United States increasing pressure on MDBs to undertake necessary reforms.
Several initiatives are at the center of this ongoing reform, including the Bridgetown Initiative, the G20’s review of MDBs’ Capital Adequacy Frameworks, the World Bank’s Evolution Roadmap, as well as calls for the reallocation of the International Monetary Fund’s (IMF) Special Drawing Rights (SDR).
On June 22 and 23, at the New Global Financial Pact Summit in Paris, global leaders met to discuss an overhaul of the international financial system and build a new financing contract between Global North and Global South countries to address the climate change and debt crises. MDB reform was a key issue on the table, and the summit pushed forward discussions on initiatives to unlock concessional finance and mobilize private finance at scale toward emerging markets and developing economies (EMDE). Highlights from the Summit include:
- The agenda for Bridgetown 2.0, which “aims to create currency exchange guarantees, add disaster clauses to debt deals and tweak the rules to enable much greater lending from multilateral lenders,” with private capital mobilization at the center. It seeks to mobilize a potential $1.5 trillion from the private sector into EMDEs by asking MDBs to 1) provide $100 billion per year to mitigate macro risks in EMDEs through foreign exchange guarantees and 2) support countries to build a strong pipeline of bankable projects.
- Support for reallocations of SDRs from developed countries to improve access to capital of EMDE to fund climate projects. The IMF announced in Paris that it has hit its $100 billion target in SDRs for EMDE. France and Japan have both promised to give away 40 percent of their SDRs.
- A Private Sector Investment Lab led by the World Bank to drive more private investment to emerging markets. The detailed plan for the new initiative will be announced in the coming weeks. As an attempt to alleviate debt pressure for vulnerable countries, the World Bank also provided plans for Climate Resilient Debt Clauses. Additionally, the Bank plans to upgrade its catastrophe insurance and create new insurance products to assist the private sector.
- Innovative, collaborative models from private and public institutions to reduce risks and attract more investment to the EMDE. Mitsubishi UFJ Financial Group (MUFG) and FinDev Canada announced their $1.5 billion GAIA project. Senegal was confirmed to be the fourth country to join the Just Energy Transition Partnership (JETP).
- An international carbon tax on shipping was also proposed. It is estimated that the tax could raise $100 billion a year, which could be channeled to EMDE to manage climate change.
While the summit has yet to yield any major decisions, it is seen as a milestone toward achieving progress on MDB reform. Notably, the summit organizers have developed a proposed roadmap with key targets, steps, and deadlines the world needs to hit in the next 18 months. Furthermore, French President Emmanuel Macron has published The Paris Agenda for People and the Planet, which reflects on discussions and acknowledges the need for reform of the international financial system and the crucial role of private finance to meet the needs of climate investment in EMDE.
Currently, however, the voice of private finance has been lacking in heated MDB reform discussions.
Private Finance Has an MDB Reform Wishlist
RMI closely follows the role of private finance in the climate crisis, engaging with financial institutions (FIs) on topics like managed phaseout and transition finance and through coalitions like the Global Financial Alliance for Net Zero (GFANZ). Hearing growing interest in MDB reform, in partnership with E3G, RMI convened key financial actors alongside the World Bank and IMF’s spring meetings in April. We facilitated an active discussion with stakeholders from several FIs, MDBs, DFIs and their shareholders on defining an active role for the private sector in the ongoing reform agenda. Participants shared their perspectives on common goals, strengthened collective understanding on reform initiatives, and identified obstacles to increasing the flow of private capital to EMDEs.
Private FIs have one main ask of MDBs: to help make EMDE climate investments bankable. The cost of capital in EMDEs, such as in India and South Africa, has been two to three times higher than that in advanced markets such as countries in Europe, reflecting the high perceived macro risk in EMDEs, in contrast to recorded actual loss and default on loans and investments. Private investors voiced concerns about the limited accessibility of concessional financing, subordinated debt and first-loss instruments through traditional financial mechanisms of the current MDB system.
As a leading voice of capital mobilization in emerging markets, Citibank, a founding partner of RMI’s Center for Climate Finance, recently released a report providing practical, implementable reforms that MDBs and DFIs can take in the short to medium term to mobilize increased private capital.
Building off the findings in Citi’s report and incorporating further consultation with the private sector, we summarize four specific ways in which MDBs and other key stakeholders can help reduce actual and perceived risks and to support FIs mobilize capital in EMDEs better:
- Create an enabling policy environment for investments by the private sector. Investors seek adherence to the rule of law and strong bankruptcy codes that will hold the sanctity of legal contracts in court. Additionally, new and rapidly emerging low-carbon technologies require targeted, long-term efforts and support at a faster rate from MDBs to help governments in EMDEs understand the latest trends and policy levers available to address market uncertainties. With their strong in-country presence, connections with governments, and access to global developments on emerging climate technologies, MDBs can play a critical role in advancing the policy dialogue at a national level. IFC’s Sustainable Banking and Finance Network provides advisory support to central banks on net-zero finance and is a great example of a program working towards climate-aligned finance policies across nations.
- Build a pipeline of bankable projects and share investment data and investment decision relevant information publicly. Many climate projects are yet to be scaled and are disaggregated across smaller ‘pilot’ investments. One challenge is that due diligence and deal structuring costs do not correspond with investors’ return expectations. MDBs can reduce such costs by providing technical support to conduct feasibility assessments, due diligence, and vet projects based on local market intelligence. They can also aggregate smaller investments into larger projects. Another challenge is that due diligence and investment performance information is not available for private investors, complicating efforts to price risks more efficiently. A quick win can begin with publicly sharing disaggregated, country-specific information from the Global Emerging Markets (GEMs) Risk Database — one of the largest information repositories from 24 member MDBs and DFIs on the credit default rates of their private and sub-sovereign borrowers. Some of this data at a high level has been made public, but more granular information would be of use to investors.
- Structure transactions and provide catalytic capital and instruments that attract private investor capital. MDBs can structure financial instruments to address specific credit, counterparty, long-term construction, and currency risks for investors. These can take multiple forms, including:
|Multiple sources of capital with different return expectations can be layered in a transaction. For instance, one tranche of investment can be guaranteed by an MDB/ DFI, and another can be covered by a pool of highly rated insurance companies to de-risk the investment for the private investor.
|Strategic debt positioning
|MDBs can start taking junior positions on investment, as they are better placed to price the risks given local market understanding, and/or structure B tranches in a manner that is taken up broadly in the capital markets (rather than a limited set of private investors).
|Mini-perm debt structures can be promoted to enable commercial bankers to provide short-tenure loans for infrastructure projects. This form of financing is usually meant to pay off the construction loans and serve as a bridge until infrastructure projects can start generating revenue. Getting commercial banks into transactions earlier through mini-perm structures helps familiarize commercial investors with the underlying assets and provides longer-term financing once the cash flows begin.
|Assets that MDBs have financed can be bundled up and broken into different tranches for sale in the capital markets. Tranche A, i.e., the senior most tranche, can be kept on the books of the MDB/ DFI. Tranche B, which has slightly more risky underlying assets, can be pooled separately. Once tranche B consists of diverse climate-aligned assets across geographies, it can be sold in the capital markets to free up money for the MDBs to invest. In the initial phase, donor support would be required to make tranche B attractive for investors.
|Currency Exchange Fund (TCX)
|Backed by DFIs, microfinance investment vehicles and donors, TCX has provided specialized currency risk mitigation solutions to hedge against the volatile fluctuations in global currency prices. Additional MDB support could scale the TCX fund and mobilize additional funding for climate investments in EMDE.
- Align internal processes and incentives for private sector mobilization. To ensure the implementation of capital mobilization approaches, there is a need for good governance practices. These could include clear and standardized key performance indicators (KPIs) (that do not incentivize lending from MDBs themselves but rather prioritize the use of guarantees and private sector funds), making capital requirements for guarantees more favorable than loans (as they can mobilize private capital), and counting guarantees as a fraction of a loan (to encourage MDB staff and national governments to opt for them).
To meet the financing gap in EMDEs, it is crucial for MDBs and private investors to efficiently leverage their resources and direct more climate investment to where it is needed most. While positive examples of MDB-centered capital mobilization exist using available mechanisms and resources, more proactive measures to draw in private capital by MDBs are needed now.
The measures and actions outlined above, and FI thought leadership demonstrated in Citibanks’s recent report, can serve as a critical starting point for private FIs to identify and amplify the specific reforms they hope to see from MDBs. Closer collaboration between the public and private financial sectors is needed, and private finance has a significant role to play in ensuring MDB reform is fit for purpose.
Discussion and efforts made at the Paris summit have boosted momentum for the reform of global financial and MDB systems. It is time for private FIs to engage with MDBs and continue to step up off the sidelines to weigh in on the game-changing reforms needed.