Development banks: blended finance is like music

In this article, the fourth in our series*, we talk about another group that can play a very important role in the blended finance symphony: development banks. There's a multitude of actors under this header, with different terms applied: multilateral development banks, international financial institutions, development finance institutions. Some of what we say below applies to all, while other points only apply to select members of this group.

To put the role of development banks into further perspective, we want to introduce another analogy besides music – one about the storage vs. the moving business. Because one of many adages in the finance world is that some banks (investment banks) are in the “moving business” – they make money trading assets for clients as an agent, advising clients on transactions, or trading for their own account as a principal – while others (commercial banks) are in the “storage business” – they make money by holding loans and bonds on their balance sheets.

Alexia Latortue, assistant secretary at the U.S. Treasury, said recently: “Private investors want to move away from fossil fuel investments, but they have to move into something. And that’s where the excitement is — how do we find the real economic opportunities for investments in clean energy.” To enable this move for private investors, we argue here that development banks should transition principally from the storage business into the moving business. Their balance sheet and capital base are finite, so their storage capacity will always be limited. “Demonstration effects” can only go so far, and with COP27 and the G20 the expectations placed on development banks are rising fast: they can point the way to that “something” private investors can move into, and they can even supply the vehicles and tools – not moving trucks and lifts but concessional financing and funds – to do the actual relocation.

For development banks to play this moving role effectively, we have four main ideas.

1. Use your rating and balance sheet to do more

This report – “Boosting MDBs’ investing capacity - An Independent Review of Multilateral Development Banks’ Capital Adequacy Frameworks”, just published last July and presented by the taskforce’s chairwoman Frannie Léautier to the G20, offers a number of excellent recommendations. There has already been some debate on the key recommendation: redefining risk tolerance. While we agree with this recommendation and think it is deserving of further consideration, we also want to highlight some of the less eye-catching recommendations, that can do at least as much to generate more blended finance.

• Give more recognition to “callable capital” – effectively the capital that signifies the commitment of the development banks’ shareholders (governments) to stand behind them. It should be fully taken into account in assessing development bank’s capital adequacy, as it already is in some credit rating agency methodologies. This should create opportunities for more lending, including the concessional kind.

• Pick up the rate of financial innovations – so that the development banks can do more with their current capital base and, again, free up room for additional lending. In doing so, development banks should take some pages out of the playbook of Wall Street and haute finance.

• Increase access to data & analysis – private sector investors have capital and are increasingly keen to move it into sustainable purposes in emerging markets. However, they desperately need access to relevant data to assess the risk & reward. You, development banks, have much of it – you should find ways to get it out into the open.

2. Implement a credible private capital mobilization strategy

The famous pop singer Sting, after his success with the Police, wanted to make a solo record with “a jazz feel”. So what does he do? He goes out and hires jazz musicians – most notably Branford Marsalis, world-famous in jazz circles, virtually unknown outside it. This approach was practically unheard of – until Sting came along, the worlds of pop and jazz were strictly separated.

Development banks should do the same. If you want to raise private capital for transactions, you won’t succeed if you don’t have a strong grasp of, and connections with, the world of private sector institutional capital. This requires an intentional capital mobilization strategy – developing relationships, convening, organizing events, hiring investment bankers or consultants who can help you design structures that meet private sector requirements. Better yet, up your game in attracting talent: doing deals with the private sector works best with staff who have worked in the private sector. And keep in mind, strategy is 10% planning and 90% implementation. Making promises is a nice prelude but will not deliver the whole symphony.

Meanwhile, be sure to not displace private sector capital, which would defeat the whole point.

3. Transform to become more nimble

We know it is a tall order to suggest development banks become more light-footed, but to successfully deal with the private sector and mobilize capital into the deals that you want to see happen, you will have to at least keep pace with the private sector. Right now, many development banks are too slow and bureaucratic, which does not bode well for implementation of your private capital mobilization strategy. Yes, you work with somebody’s tax dollars, which comes with extra oversight and scrutiny. But to meet increased expectations and live up to your missions, you’ll need to strike a better balance between rigorous processes and real-world timelines. You may consider delegated credit authorities, certain projects with higher risk-tolerance, or fast-tracked dealmaking in sectors with urgency such as food security and energy transition. The liquidity operations during COVID showed us you can pull it off.

4. Do more moving, much less storage

To extend the analogy introduced above, the most radical idea is to structure your private sector transactions for placement with institutional investors while keeping a portion on your own balance sheet, offload risk exposure from your balance sheet to investors, or securitize certain eligible assets. Investors always complain that there is enough capital but not enough bankable deals in emerging markets – you can change that. A development bank’s balance sheet and capital base are finite resources and should be used selectively. This would be a very different approach to development banking that would require massive upskilling, reskilling and different talent recruitment and management. It also requires very different underwriting and structuring approaches, and deep knowledge of what sells in the marketplace. The rewards include freeing up lots of your capital and a successful private capital mobilization strategy, and, most importantly, more and faster sustainable development outcomes in your markets.

To bring this all back to our music analogy: blended finance is like a symphony – you need many different musicians, all playing their unique part. Development banks should transition from the storage business to the moving business: you can bring the musicians and their instruments to the concert hall; you can hoist the grand piano onto the stage and you can put the sheet music on the stands that allows the orchestra to move to new and unexpected musical horizons.

This requires using your rating and balance sheet to greater effect – the G20 CAF report can be your sheet music – it requires implementation of a credible private capital mobilization strategy, and a transformation into more nimble organizations to at least keep pace with the private sector that you want to involve in the deals you orchestrate.

* Perhaps you haven’t seen the first three articles we wrote comparing blended finance to music. The basic idea of the analogy is that to play a symphony you need lots of different musicians, playing the parts only they can play – it’s no different in blended finance. In each article in this series we’re talking about who those different ‘musicians’ are that are needed on the blended finance stage – and how to get them on stage! You can find them here (on Governments), here, (on Asset Owners) and here (on Foundations).

[Why Blended Finance is Critical

Most projects and activities that are needed to achieve the SDGs are not profitable, or not profitable enough, or not yet profitable. Also, most are small scale. And most are in emerging markets. At the same time, we need trillions annually (estimates vary) to flow to these activities, much, much more than governments, NGOs and charities have. So, we need institutional investors like pension funds and insurance companies because that’s where the money is. However, they do not invest in small-scale, emerging markets projects that are not profitable. Also, it’s unlikely we can persuade pension fund boards to make impact-first investments at scale – their primary aim is to invest on behalf of pensioners which comes with strict investment criteria. Also, none of the existing ESG activities (labels, ESG funds, green bonds, ESG integration, SFDR, PRI, TCFD, Taxonomy, Net Zero) are achieving any of this. So, if we want to scale this up fast in order to meet the 2030 deadline, we need to start tailoring the needed projects so that they do meet institutional investors’ requirements, and this is what blended finance does: government (or DFI or philanthropic) interventions such as guarantees, first-loss positions, grants, technical assistance, subordinated debt or junior equity, can change the risk/return profile of impactful projects enabling institutional investors to allocate capital to them.]

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Cover photo: Balinesisk gamelan by Benjamin Hollis CC BY 2.0