What does it take for a Development Bank to succeed?


By João Carlos Ferraz, Instituto de Economia, Universidade Federal do Rio de Janeiro, Brazil

This blog is part of an ongoing series evaluating various facets
Development in Transition. The 2019 “Perspectives on Global Development” on “Rethinking Development Strategies” will add to this discussion

bank-finance-growth-financePublic finance institutions, or development banks, have “development DNA”. But, can they effectively engage in financing “development in transition” or the call to rethink international co-operation to help countries at all levels of income sustain their development gains? What would it take for such institutions to succeed? How can they anticipate and effectively respond to societal and market needs and aspirations?

Political space for this does exist. A consensus exists that development banks must have at least four priorities: infrastructure, innovation, sustainable environment and firms of smaller size. That’s the easy part! No policy maker or analyst in their right mind would be against these priorities. But, consider the nature of these priorities: each one is time- and place-specific but evolving permanently; they are moving targets. More importantly, they are risk-intensive, given the duration and unpredictability of associated projects and/or the potentially low credit worthiness of economic agents pursuing these priorities.

Thus, to effectively address these priorities, which are key for economies transitioning from one level of development to the next, public finance institutions rely on at least five pillars to sustain their missions: scale and scope; financial capacity; technical autonomy; appetite for development and, societal interests. Why do each of these pillars matter for development banks to succeed?

First, scale and scope: Since unit costs decrease with increasing volumes of transactions, further reductions are obtained through a diversified portfolio of financial products and services. Development banks that make a difference are sizeable institutions. In Brazil, China, Germany, Korea and Italy, the asset-to-GDP ratio of their development banks varies from 13% to 24%. And, worldwide, diversification is a prevalent feature. Behind this is a financial reason: risks and rewards are “portfolio managed”; higher risk operations are compensated by those with foreseeable, stable returns.

Second, financial capacity: To finance risk-intensive projects, institutions must maintain sound, long-term balance sheets, allowing them to take risks without affecting capital bases. Profitability is, of course, critical. However, what is, perhaps, more important is having in place a funding structure (cost and duration) on par with risks taken to aim for a profitable balance. In fact, development banks worldwide use different combinations of support instruments to achieve this balance, such as sovereign guarantees, non-payment of taxes and/or dividends, and access to parafiscal resources.

Third, technical autonomy: Effective public policies rely on executing agencies with technical autonomy, or the internal capacities to discern, foster, implement and monitor projects consistent with policy guidelines. Technical autonomy across public finance institutions is seen through impersonal and collective financial decision-making processes, together with independent evaluations of credit risks. For that, personnel of intellectual and technical excellence are essential. Thus, employees must be competitively selected, enticed by comfortable and predicable salary conditions and explicit and permanent investments in learning processes, especially in novel ways to anchor and evaluate financing decisions.

Fourth, an appetite for development: Risk appetite is associated with the level of risk an institution is prepared to accept in pursuit of its objectives, and before action is deemed necessary to reduce risks. Such appetite tends to lean towards conservative attitudes. However, development banks must be willing and capable of incurring risks and reaping rewards associated with development objectives. An appetite for development requires not only a sound capital base, but also funding sources and risk evaluation systems. Guarantee policies must go beyond traditional sources of collateral, particularly in the face of the intangibility of development projects and, above all, of decisions based on ex-ante impact evaluation methods, reflecting indicators to be monitored throughout the life of a project and its aftermath.

Fifth and finally, societal interests: Every public development institution must be aligned with public policies, cultivate partnerships with the financial sector, consider the needs of beneficiaries and interact with segments of society impacted by development projects. Interaction with society is fundamentally important for development institutions. Differences of interests are permanent; relational tensions cannot be discarded nor ignored but rather accepted and handled. Actions without consultations are undemocratic. And the belief that economic agents do not lobby for their interests is very naïve. Development banks live with the contradictions; they not only deal with the interests of the beneficiaries they finance, but also face groups impacted by their actions. The role played by each actor, in each project, must be made explicit to avoid capture, mitigate negative externalities and leverage the positives. For that, development banks must negotiate continuously with all partners. After all, to arbitrate interests, having the public good as the reference is the “karma” of public policy practitioners and reaffirms the ‘’development DNA’’ at the core of public finance institutions.

See the author’s blog reposted to the UCL IIPP blog.