Reimagining MDBs: The critique blended finance needs

Uxolo: Why should the private finance sector work with MDBs in emerging markets where there is greater risk and smaller returns?

Manfred Schepers (MS): My basic premise is looking at the glass from a half full perspective – I am inherently positive about the role of MDBs. I learned from my experience running the capital markets business for UBS for over 15 years that the banking and capital markets system, to an extent, do not directly serve the real economy where it is most needed. It is a way of general financing supported by trading venues, but the actual purpose of finance can become lost. When I joined EBRD and experienced the financial crisis from the MDB-side, I learned how finance can be provided through the lens of public good.

The shareholders of the World Bank Group, AfDB, ADB, EBRD, EIB, and IDB share a consensus on what they collectively think is for the public good. For one, this is because the bulk of their shareholders are the G7 members and are effectively global policy setters who are working with recipient countries. That is a very powerful model and it is very different to the rest of finance where the society in which finance takes place is generally not party to the purpose of finance. The involvement of multilaterals in setting policy and objectives and measuring outcomes is therefore exceptionally powerful.

Sometimes it can be sclerotic and people can critique their speed and their bureaucracy but it is a bit like the COP conferences: damned if you do, damned if you do not. Are we going to address public goods alone? You can see with climate change that there is no chance of us trying to do things on a national basis, and the same applies to immigration, to healthcare, and to the food chain. But public capital can only stretch so far and, ultimately, if capital is not provided by the public sector, it needs to be provided by the private sector: there is no in-between.

Uxolo: What is preventing greater volumes of private sector mobilisation and blended finance transactions?

MS: If you want to have the public sector and the private financial sector both financing the private economic sector, there needs to be transparency on how you are doing that. Just look at the way finance has evolved over the past decades; it has always been on the basis of creating greater market transparency in the inherent risks and returns of investments. Greater disclosures in equity, in the bond market, in the derivatives market – these markets grew because there was increased transparency and people could understand the risk and return and compare their choices.

We have regulation and voluntary market standards for a reason. It is not just the regulator saying it, the market also quite often says “if we do it this way, we can all be better”.  The financial crisis was created through non-transparent instruments causing asymmetric risk allocation which basically means when people do things they think look good and take risks they do not understand, the financial system will try and load the most amount of non-transparent risk on the least knowledgeable investors – it is called the greater fool theory.

The transfer of true risk requires transparency, standardisation and harmonisation, otherwise you do not know where you are between the real risk of these projects and the AAA status of the MDB – if it is not transparent, then how do you know whether what is underneath is rated AAA or B? Currently, people are looking at effectively non-market instruments, what they call blending, and facilitating transactions that otherwise would not take place in a non-transparent manner and in a way where it is unclear which risks are being taken by whom. If we are going to look at ways of utilising other financial instruments to mobilise more capital at scale, it needs to be done on the basis of transparent underlying data.

MDBs are playing this critical role as an intermediary to create transparency, standardisation and harmonisation in the emerging markets they operate in – and they do an outstanding job. The problem is that that business model has not yet turned itself to mobilising private finance – we are only at the beginning of that conversation.

Uxolo: Should MDBs be playing a greater role in de-risking blended finance transactions?

MS: There is so much pressure now to mobilise climate finance that the private sector is pointing the finger at MDBs and governments saying “you need to de-risk, otherwise I cannot invest”. And, I am getting a little irritated by market participants saying, “well, I’m happy to lend as much money as you want to emerging markets, so long as it is guaranteed by an AAA MDB”. If you want to have World Bank risk, you can buy World Bank bonds. But then you will merely mobilise AAA liquidity, not risk-bearing capital.

We are talking about inherently illiquid assets. You cannot make an illiquid asset liquid just by calling it liquid, which is why I’m not a big believer in these credits being transferred into tradable instruments, including securitisation, as the liquidity is often not reliable. You can only do securitisation if you have good underlying data, otherwise you are going to be heavily dependent on some form of concessional first-loss or guarantee, and then, why bother? If I do a securitisation and it has a form of guarantee from an MDB, why not just purchase an AAA MDB bond? Of course, if you can get less risk for the same return, that is the most logical thing that can be done. But the MDBs are not going to provide investors with a less liquid guaranteed instrument at a yield that is higher than their own bonds. That is the reason MDBs don’t provide full guarantees – they do not want to dilute the pricing of their own AAA bond issues.

The problem is that MDB AAA bonds do not raise the additional risk capital which is necessary to address all the development and climate finance requirements across emerging markets. The MDB system does not need additional investors to buy AAA bonds; they need investors that are willing to take full project risk – like ILX which invests in loan participations pari passu, where the MDB remains the lender of record. In these loans, our legal counterparty is the MDB but we take full risk on the underlying borrower.

We need to avoid market distortion through unnecessary subsidies and concessional finance. If we are going to use that, it really needs to ensure the benefits of that concession are going to the underlying projects and beneficiaries. It needs to be used in environments where private sector finance just cannot go – low-income countries, post-conflict countries, countries badly affected by climate change, and for climate adaptation projects and new technologies.

Uxolo: Most people would agree that ILX Fund is a strong example of effectively mobilising private finance – why do you think no one is copying this example, such as within the commercial sector?

MS: What is so unique about ILX? One reason is that it requires very specialist knowledge; we are not trading bonds, we are making long-term individual project investments in development finance loans that involve specialised knowledge of emerging market project, financial institution, and corporate finance. Secondly, we enable investments globally through our MDB/DFI partnerships. And, thirdly, we come from the development finance world – we have a network of development finance specialists across MDBs and DFIs, which is not natural to traditional bond and alternative asset managers.

Fourthly, the cost of the strategy needs to be low because inherently the asset class is very stable. The returns are attractive against similar assets, but that stability makes it impossible to charge a performance fee: what we say is our likely return is the return we are earning today; we expect low and predictable losses. This business model is therefore very difficult for traditional private credit and alternative asset management businesses that are based on performance-based fees and compensation.

ILX relies on the reputation of MDBs and DFIs – on their expertise, track-record, their stakeholder network, their country and sector knowledge, and their lender of record status – this is our business model. That is what allows our costs to be kept low; we do not need to have a physical global presence and we can minimise international travel to emerging markets, which is all part of our strategy to strive for an efficient and sustainable business model which will mobilise private capital at scale.

But, the MDB system can offer unique benefits deriving from its institutional privileges and immunities: although preferred creditor status only applies to the sovereign risks, private sector operations do benefit from tax and legal immunity and exemption from transferability and convertibility risks, and foreign exchange moratoria. And there is significant room for scaling up the MDB sharing of their lender of record status through their B-loans programme which, in theory, could be scaled up to hundreds of billions as these assets are no longer on the MDB balance sheet: they are deconsolidated. By utilising this, MDBs could scale up their originate to distribute objectives.