Network Voices is a series where Convergence amplifies blended finance opinions and activities from our network - this op-ed was originally published in our State of Blended Finance 2021 report.

*By Nancy Lee, Senior Policy Fellow, Center for Global Development (CGDEV) *

Despite criticism of the “Billions to Trillions” action plan, we know that catalyzing much larger volumes of private finance for SDG-related investments remains the only viable avenue for achieving the scale needed in developing countries, given very real constraints on fiscal space and on growth in foreign aid.

In fact, the private sector itself is turning a corner, in word if not yet in deed. The giants of global wealth management, private equity, and institutional investment view green and social investments as essential, both for reducing global risks and for capturing sustainable returns. The challenge is to direct more of it to emerging markets and poor countries.

So far, the MDBs remain marginal players in turning this vision into reality. The available data suggest that MDBs collectively mobilize $1.5 of private finance for every dollar they commit on their own balance sheets. For their blended finance operations (combining commercial and concessional finance), in 2019 they mobilized a total of $3.1 billion in private finance, less than their own commitments of $5.1 billion. It is important to understand why. The reasons are fundamental and embedded in their business models.

MDBs operate as low-cost-of-capital commercial banks, leveraging shareholder capital through market borrowing and lending to public and private clients at higher, but still favorable, rates. The interest spread funds their programs and can even add to their capital over time.

This model works well for lending to governments where the principal aim is to maximize the volume of MDB finance in order to add to public spending for social, infrastructure, or productivity enhancing purposes. When private banking sectors barely functioned in developing countries, it worked well for private borrowers with no alternatives.

But the world has changed. In most of the developing world, there are functioning banking sectors. The problem is they don’t lend enough, especially to where it is most needed for poverty and inequality reduction, countercyclical crisis resilience, or combatting the effects of climate change.

For understandable reasons, MDB finance models lead to a focus on:

• The volume of their own transactions, the principal basis that shareholders and others use to judge their performance and to assess when additional capital is needed;
• A preference for lending over instruments like guarantees and equity, though the latter perform better in mobilizing private capital;
• A staff skill mix heavily concentrated in low-risk senior lending, with low NPLs and write-offs;
• Risk-adjusted market returns (not required for financial sustainability);
• Approaching risk from a commercial banker’s perspective;
• A preference for senior positions in capital stacks, which leads to competition among themselves and with private actors with similar preferences; and
• A reluctance to work in countries and sectors where transaction costs are high and thereby eat into MDB profits.

All this suggests that fundamental changes to the model and governance are needed for greater catalytic and impact power. The following proposals address core problems in incentives, mission clarity, and value for money:

1. Set mobilization of private finance as the number one institutional target. Only one institution so far, the IFC, has set any explicit mobilization target, and its fiscal year 2020 target for private and public finance mobilized, at $10.8 billion, was modest when compared to its own commitments of $11 billion. Going forward, the mobilization target is 80 cents for every dollar of IFC commitments, and that includes mobilization from other public sources.

2. Target financial returns adjusted for impact. Impact should be defined in both development and emissions terms. This could well mean accepting below-market (but positive) financial returns at the portfolio level.

3. Focus operations on critical gaps in capital markets and on instruments best suited to addressing these gaps. Examples include early-stage finance (including first loss guarantees and equity) for firms and infrastructure, local currency finance, and finance for sectors with positive development and environmental externalities that private investors cannot fully capture.

4. Establish systematic collaboration between the public and private arms of MDBs. This is essential for identifying and reducing the sectoral investment risks--including policy, regulatory, and institutional barriers—that constrain bankable/investible project pipelines.

5. Shift from the originate-and-hold model to an originate-and-transfer model for part of the portfolio (while avoiding reduced risk tolerance and development focus). Later stage transactions, or transactions with demonstrable profitability, could be bundled and sold to investors, or part of their associated risks transferred to private guarantors or insurers for a fee, freeing up some MDB capital for more operations (as in the AfDB’s Room2Run).

6. Deploy more concessional finance where it is most needed. Boosting impact means taking on more risk, reducing risk, or bearing the costs of making more transactions bankable or investible. Realistically, this means that MDB private finance arms are going to need more concessional finance, but only if they can demonstrate that diversion of such scarce funds from public to private finance operations yields more scale and impact.

How to demonstrate this last point? By tackling the toughest, most pervasive development challenges in a way that promotes competition for scarce public resources. Much private sector development involves the search for products, services, and business models that work in low-income environments. It follows that MDBs would do well to concentrate on promoting scalable innovation and bearing part of first mover risks and costs. Arguably the biggest successes in private sector development, where MDBs have played a key role, have been the making and growing of new business models and products, like mobile financial services, commercial microfinance, and household and off-grid renewable energy. Grants and other concessional finance have been essential in supporting scalable innovation, especially in poorer countries.

But MDBs must have workable mechanisms for avoiding the uncertainties and distortions of picking winners and losers. Making concessional resources available in competitive challenges, the terms of which maximize development/climate benefits relative to public subsidy dollars, should be the preferred means of deploying concessional resources to the private sector. One powerful, but underused, business line for MDBs in this regard is outcomes or performance payments, which intervene on the revenue (rather than cost or risk) side in a manner which allows the private sector itself to build a workable finance plan around an outcome-dependent revenue stream.

None of this will be possible without more clarity from shareholders in their strategic oversight of MDBs. Shareholders must be willing to explore and then challenge management and staff to launch major institutional change, if MDB are themselves to become major agents of change in private sector-led sustainable development.