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The 10 challenges facing Development Finance Institutions

07-Oct-2018

National and international development finance institutions (DFIs) are specialised banks set up to support economic development. They do so primarily in developing countries, but also in advanced ones to address specific market failures in certain regions or sectors of the economy. They are usually majority-owned by one or several governments, but sometimes private sector operators participate as well. In many respects, DFIs follow the same rules and use the same instruments (loans, credit lines, equity investments, guarantees) as commercial banks. The difference lies in their mandate or mission, which focus on softer objectives such as economic development, poverty alleviation, economic integration, promotion of market economy, job creation, fighting climate change, gender equality etc. They usually take more risk and adopt a longer term perspective on project return than regular commercial banks. Moreover, their shareholders do not require a specific return on equity, which relieves DFIs of the pressure linked to economic performance and profitability. Because of these differences, DFIs face specific challenges not encountered by commercial banks.

1. Measuring the fulfilment of their mandate.

Unlike commercial banks, which objectives can be simply expressed and measured in monetary terms like profitability and shareholder value, DFIs have political mandates, with often soft or qualitative objectives by nature difficult to measure. Assessing their relative success or failure in accomplishing their mandate is therefore difficult. It is nevertheless essential if one wants to select the most effective strategy, thus maximising the impact of tax payer's money. This requires:

- a precise formulation of the mission and the definition of KPIs matching that mission;

- the effective and factual assessment of the DFI against these KPIs by independent economists or accountants;

- the implementation of a system across the DFI that effectively ranks projects against mission benchmarks, so that those projects achieving the highest score can be prioritised and those failing the test can be abandoned.

2. Formulating an actionable strategy.

DFIs are expected to operate at the forefront of societal and economic change. They act as scouts and pioneers, setting an example in fields as diverse as sustainable development, gender equality, corporate governance, environmental responsibility. Like any organisation, they need a strategy to guide them towards meeting their objectives. This may be made more difficult at DFIs given certain soft aspects of their mandate and the nature of their governance, often complex and prone to political interference. To be effective, the strategy has to be:

- realistic, and therefore resulting from an internal process of not only top-down but bottom-up elaboration, taking into consideration the experience and feedback from the operational teams;

- clear and measurable, with targets defined by sector, geography, product ...

- consulted with shareholders, other stakeholders (NGOs ...), approved at the highest level (Board of Directors, AGM ...), communicated to staff and publicized externally.

3. Making good credit decisions.

Avoiding a high level of Non Performing Loans is as important for DFIs as it is for commercial banks. For one, it allows them to be sustainable and thus continue carrying out their mandate without need for further capital injections (saving tax payer's money). Moreover, making good credit decisions has another dimension for DFIs as a demonstration effect for the commercial sector and the public as a whole. In so doing, DFIs face specific challenges, the strongest ones being (i) underwriting weak loans for the sake of volume targets; (ii) political interference in the selection of projects and (iii) corruption. This may be avoided in a number of ways:

- an internal organisation with a clear separation of duties between the operational client-facing teams on the one hand and truly independent teams assessing credit, environmental and compliance risks on the other;

- a good mix of staff of various origins and a Board of Directors reflecting different geographies, backgrounds and agendas, acting as a foil for patronage in a particular sector, region or country;

- the recruitement of competent employees, their training and their rotation.

4. Attracting private sector funds, not competing with them.

The tightening of budgets worldwide makes the mobilisation of private sector funding in support of development projects a necessity. With generally low cost of funding and lack of necessity to achieve a return for shareholders, it must be a temptation for development banks to write facilities to the strongest customers, who could probably obtain equivalent facilities from commercial banks but on less favourable terms. In so doing, DFIs would not only fail their mandate, but would have a damageable eviction effect on the private sector. This can be avoided by:

- inviting private sector investors and lenders to join in the financings where the development bank would take the senior and longer term debt. Their participation would demonstrate that the financings take place on market terms;

- having a rigorous risk / pricing matrix, rating each project;

- researching the market to place the DFI in the wider landscape of available sources of finance;

- having in place a mechanism to acknowledge eventual complaints regarding unfair competition.

5. Cooperating with other national and international development banks.

The desire to accelerate economic development, as well as geopolitical agendas and competition for influence, have fostered the creation of new DFIs, some resulting from an international effort and some being established by their respective national governments. Although the needs are immense, there is a risk that too much money chases too few good projects, resulting in poor resource allocation and counter productive competition. It is necessary to:

- develop particular specialisations and expertise, complementing those of other DFIs;

- consult with other DFIs during the elaboration of the strategy, to make sure that overlaps are avoided and conversely eventual markets gaps covered;

- meet on a regular basis with other DFIs operating in the same area to exchange information, find concrete synergies and cooperate on specific operations through co-financing;

- improve mutual recognition by the reciprocal exchange of staff through secondments.

6. Reaching out to SMEs.

In most markets, SMEs tend to be discriminated against on account of their higher risk profile and lower profitability for banks. What is true in developed markets is even more acute in developing ones, where the weaker legal and business environments render SMEs even more frail. Moreover, DFIs are sometimes driven by the urge to achieve quick and visible results for political reasons. This may lead to emphasize infrastructure or large corporate projects. However focusing on larger projects (of which there is often only a small number) would betray the DFI's mandate. In every country SMEs and micro-enterprises represent an important source of job creation, innovation, and market-oriented grass-root projects, with great local impact. This is where the next generation of business leaders and national champions may be found. It is therefore necessary for DFIs to make a special effort towards micro-lending and SMEs, especially if the local environment discriminates against them. This is a long term endeavour, which necessitates:

- create SME-focused teams with special sets of incentives not volume-driven;

- develop facilities providing wholesale finance to selected financial intermediaries with a sufficiently large branch network, for on-lending to SMEs at local level;

- facilitate trade finance, often a good way to provide focused finance to smaller local companies;

- support local advisory networks providing business advice to SMEs, through technical assistance or cooperation agreements.

7. Local currency lending.

The Asset-Liability Management of DFIs is somehow facilitated by the longer term nature of their funding, reducing liquidity risk. Currency and interest rate risks can be mitigated by lending in "hard", easy to hedge currencies, which may be their currencies of funding. However, this means shifting those risks to the clients, who are often ill-equipped to manage them, or may even be unaware of them, lured by the prospect of lower interest rates and longer maturities. Local currency lending is particularly important to serve SMEs or less sophisticated clients not mastering the concept of currency risk. Finally, local currency lending may have a strong demonstration effect by offering to the currency concerned a higher standing and recognition by the international community, and through the development of funding and hedging instruments by the DFI. Local currency lending requires:

- political will at the level of the DFI to be prepared to undertake the higher risks involved and engage with the governments concerned;

- policy dialogue with the central bank to establish the right regulatory framework;

- innovative and apt treasurers, ready to work through the challenges of local currency funding, for instance by issuing local currency long-term bonds.

8. Striking a balance between supporting the private and the public sectors.

As public institutions, it is tempting for DFIs to focus their activity on large infrastructure or public projects. This may achieve high impact on the economic conditions of the country concerned and improve the lives of many, while creating much sought-after visibility. At the same time, through the promotion of private and entrepreneurial initiative, DFIs can achieve grass-root development and contribute to the emergence of marketā€oriented economies. An efficient infrastructure will help the private sector strive, but conversely a strong private sector will justify investments made in infrastructure. The case for DFIs getting involved in private sector development is therefore clear when market failures entail that the private sector cannot receive the level of financial support it needs. This support can take several forms: (i) corporate lending (ii) equity investment (iii) technical assistance. DFIs themselves may benefit from maintaining a significant private sector activity, since it tends to instil discipline in investment decision making and keep a healthy contact with the real economy. Balancing private sector and public sector activities requires:

- a clear strategic intent from the shareholders, which may be reflected in the statutes of the DFI with certain ratios to be met between public/private investment;

- separate teams with different sets of objectives, since the project cycles and approaches can be very different;

- employees with corporate banking experience, and equity investment experience in the case where equity investing is an objective of the DFI.

9. Determining the right level of capital.

DFIs source their equity capital from governments or benefit from government guarantees.

This ensures their creditworthiness, which enables them to raise large amounts of money on international capital markets and provide financing on very competitive terms. However in the absence of a target return on equity or market-based determination of the cost of capital, it can be tempting to overcapitalize DFIs, which would be a waste of public resources. The key is to apportion the capital to the mission, objectives and needs of the DFI. This can be achieved through:

- modelling the activity, taking into consideration the planned commitment volumes and risks, macro-economic scenarios and subsequently determining the level of capital necessary to carry out the activity while maintaining the standing of the DFI on capital markets;

- distinguish between authorised and paid-in capital, the latter being smaller to reduce the pressure on governmental budgets;

- cooperate with trusted commercial or other public partners, for instance by using guarantee instruments which could trigger a higher amount of commercial lending in specific situations, thus leveraging the DFI's capital.

10. Attracting and retaining the best staff.

DFIs are in competition with the private sector to attract talent. They are often at a disadvantage when it comes to absolute levels of remuneration. At the same time they offer job stability and a sense of purpose, which can be strong motivations to join and stay. At the same time for existing DFI employees, moving to a commercial bank can be a challenge because they may have less experience in negotiating profitable margins, acceptable maturity periods and collateral requirements. The risk is to create life-long employees, eroding efficiency, motivation and competence. A healthy turnover should ensure that new blood is regularly brought in while long-standing employees know that bridges exist with the private sector, offering professional perspectives outside of the institution. DFIs even more than commercial banks need to:

- have a system of performance-based remuneration allowing to compensate the best talents;

- rotate staff through various jobs/positions to maintain them fresh and motivated;

- use vocational training to keep the technical competences up-to-date;

- second employees to other DFIs or commercial institutions, to broaden their experience and skills.