Concomitant with the annual 2022 G20 meeting of Heads of State and Government in Bali, Indonesia, the third annual G20 meeting of Finance Ministers and Central Bank Governors (FMCBG) released their first-ever independent report on Multilateral Development Banks’ (MDBs) Capital Adequacy Frameworks (CAFs). The goal of the report was to create an action plan to loosen the capital adequacy policies of MDBs and create new benchmarks in order to address a challenging combination of both an increase in short-term crises and longer-term investment needs by the developing world.
The G20’s independent report stressed that MDBs are currently constrained by policies that limit the amount of capital that they can generate for development investments and to address short-term financing crises. These restrictions limit how much risk MDBs can undertake while still maintaining adequate reserves to absorb losses in the event of a borrower default or when the market value of the MDB’s assets falls.
MDBs are in a unique position compared to commercial and retail banks in that they are entirely unregulated by domestic law and thus their shareholders are solely responsible for determining an MDB’s capital adequacy policies. As such, the G20 independent review urgently called on shareholders and their partners to make adjustments to capital adequacy policies in order to meet the growing needs of developing countries.
A perfect storm
The authors of the G20 independent report noted that the world is facing a “perfect storm” of proliferating crises, rising debt levels, and paralyzing fiscal constraints as countries struggle to implement the UN 2030 Sustainable Development Goals.
The response to the Covid-19 pandemic resulted in a significant downturn in the global economy, pushing at least 100 million people back into extreme poverty. Further disruptions in the supply chain and multilateral sanctions have also contributed to a “dangerous inflationary trend” with far-reaching economic and social consequences, making the development world in need of more financial assistance than ever before.
MDBs play a key role in development, generating more than $167 billion in funding in 2019 alone, but the report stressed that many public sector projects, including rural electrification and maternal health, are struggling to attract adequate investments even though they are essential for poverty reduction, climate resilience, and achieving other SDGs. Therefore, the CAFs need to be modernized in order to make bond issuances by MDBs more attractive on the international capital markets.
Indeed, one of the challenges facing shareholders interested in amending an MDB’s capital adequacy framework is the need to ensure that the methodologies used by third-party credit rating agencies to assess a bank’s assets are in line with any new CAF policies. Currently, many MDBs work closely with credit rating agencies to provide risk valuations of the bank’s loans on the international market as well as portfolio assets such as bonds and other financing instruments. Therefore, MDB shareholders will need to work closely with credit rating agencies in order to implement any changes to a bank’s CAFs.
The authors of the independent review noted that MDBs play a significant role as policy tools. Most governments have granted MDBs “preferred creditor treatment” (PCT) which means that sovereign borrowers will continue to repay MDBs even if the country goes into a default or is forced to delay repayments to other creditors. As such, MDBs have a track record of very few incidences of economic losses, giving MDBs plenty of cushion to relax their capital adequacy frameworks without accruing additional risk to shareholders.
The decision to conduct an independent review of MDB’s CAFs was agreed upon in July 2021 at the G20 meeting in Italy. The review was helmed by the Indonesian presidency of the G20 under the leadership of finance and development expert, Dr. Frannie Léautier, and a team of 13 designated experts selected by the G20 International Financial Architecture Working Group.
Input for the report was received from the staff at Asian Development Bank (ADB), African Development Bank (AfDB), Asian Infrastructure Investment Bank (AIIB), Development Bank of Latin America (CAF-DBLA), Caribbean Development Bank (CDB), European Bank for Reconstruction and Development (EBRD), European Investment Bank (EIB), Inter-American Development Bank Group: Inter-American Development Bank (IDB) and Inter-American Investment Corporation (IDB Invest), Islamic Development Bank (IsDB), New Development Bank (NDB), International Bank for Reconstruction and Development (IBRD), International Development Association (IDA), International Finance Corporation (IFC) and the Multilateral Investment Guarantee Agency (MIGA). Input was also received from Louis Arnaud of Fitch Ratings, Alexander Ekbom of Standard and Poor’s, and Kathrin Muehlbronner of Moody’s.
During the G20 Finance Ministers and Central Bank Governors (FMCBG) meeting in Indonesia, leaders pledged to develop a roadmap to implement the review board’s recommendations in consensus with all member nations and credit rating agencies.