Development finance institution


Development finance institution

Development finance institution (DFI) is generic term used to refer to a range of alternative financial institutions including microfinance institutions, community development financial institution and revolving loan funds.[1] These institutions provide a crucial role in providing credit in the form of higher risk loans, equity positions and risk guarantee instruments to private sector investments in developing countries[2]. DFIs are backed by states with developed economies. In 2005, total commitments (as loans, equity, guarantees and debt securities) of the major regional, multilateral and bilateral DFIs totalled US$45 billion (US$21.3 billion of which went to support the private sector)[2].

DFIs have a general mandate to provide finance to the private sector for investments that promote development[2]. The purpose of DFIs is to ensure investment in areas where otherwise, the market fails to invest sufficiently[2]. DFIs aim to be catalysts, helping companies implement investment plans and especially seek to engage in countries where there is restricted access to domestic and foreign capital markets and provide risk mitigation that enables investors to proceed with plans they might otherwise abandon[2]. DFIs specialise in loans with longer maturities and other financial products. DFIs have a unique advantage in providing finance that is related to the design and implementation of reforms and capacity-building programmes adopted by governments[2].

Contents

Subsidies

The term ‘subsidy’ is used here in its broadest terms (an explicit or implicit transfer from the public sector (here: the state backing the DFI) to the private sector)[2]. These transfers result in different conditions available in DFI operations than would be normal practice in the commercial financial sector[2]. Transfers can be aimed at private sector beneficiaries directly (e.g. in the form of interest rate subsidies) or indirectly through its effects on the conditions under which DFIs are allowed to operate (e.g. lower costs of capital because public shareholders do not require commercial rates of return on their investments)[2].

This definition includes a broad spectrum of issues, and goes beyond technical assistance grants in infrastructure to the raison d’etre of DFIs because without some transfer of finance or guarantees, DFIs would not be able to invest in infrastructure as they do at present[2]. There are three main forms of subsidies in the operations of DFIs in practice[2]:

  1. High level of liquidity;
  2. An ability to access technical assistance funds; and
  3. Subsidies passed on directly to beneficiaries.

High level of liquidity

DFIs' levels of liquidity are higher than in commercial banks, because of large levels of paid-in stock, additional ‘callable’ capital, exemptions on dividends and corporation tax (for example, IFC, EBRD, CDC Group, DEG, Proparco and EIB are all exempt from paying tax on profits), the cost of borrowing at sub LIBOR due to their institutional AAA credit rating, an implicit state guarantee and income from trading in borrowings[2]. DFIs' mandate requires such liquidity in order to invest in developing countries. High growth in many developing countries allows DFIs can obtain strong returns on equity investments and in the period leading up to the crisis they enjoyed high levels of income[2]. The IFC's total capital (capital stock plus designated and undesignated retained earnings) are almost equal to their total commitments of loans, equity and debt securities, and their institution’s capital adequacy ratio has risen from 45% in 2002/3 to 57% for 2006/7[2]. Another DFI's, the FMO, capital adequacy has increased from 38.4% in 2000 to 50.5% in 2005, while the CDC’s rate of return is stronger than emerging markets stock market indices.

An ability to access technical assistance funds

DFIs also provide a substantial amount of technical assistance (TA), and a survey by researchers at the Overseas Development Institute found that DFIs spend over US$ 200 million on TA to both the private and public sectors to help develop private investment projects[2]. Services are either other paid for with a fee (on a cost sharing basis) or in the form of a grant, funded by the DFI’s retained earnings[2]. TA funds are sometimes tailor made for specific projects and clients, while others for cater for a broader, upstream, investment climate or financial reform programmes[2]. Not all these TA funds are directly administered and controlled by DFIs, some are merely accessed or influenced by them[2].

Subsidies passed on directly to beneficiaries

The subsidy directly passed on to the client is usually in the form of a risk guarantee and/or a longer repayment period[2]. DFIs can often provide loans for between 10 to 15 years, far longer than a commercial bank's loan of usually 3-5 years[2]. In the case of the EIB, loans can last up to 25 years[2]. Other benefits provided directly to beneficiaries include: longer grace periods; subordinated debt or other forms of quasi-equity finance characterised by higher risk; equity investments in frontier markets and sectors; and the higher risks that accompany the syndication of loans[2]. Yet these loans are not understood to damage the competitiveness of the commercial banks, as the lending policies of DFIs reflect their mandate that debt should be priced at a mark-up which reflects genuine country and project risk, and includes administration costs and fees at market rates[2]. Despite differences amongst DFIs at project level, this mandate tends to be properly applied in practise[2].

DFIs and Risk

DFIs' mandate requires them to invest in areas commercial banks do not, towards poorer countries and sectors and as hence they face higher risks[2]. DFIs must help markets grow and seek to improve the investment climate, in order to demonstrate that enterprises can develop in economically challenging markets, thus contributing to sustainable development[2]. However, since private capital must also be involved and their continued investment in future projects ensured, a commercial return must be achieved[2]. Yet DFIs seek to resolve these two conflicting factor through an 'optimum' level of risk by balancing the cost of managing elevated levels of risk (e.g. loss provisions on loans, guarantees and equity impairment revaluations etc.), with the need to maintain liquidity sufficient to ensure strong institutional credit ratings, a low cost of borrowing, and generate a surplus to support technical assistance and grants[2].

Experience might suggest DFIs have operated at an optimum, for instance, during the Asian financial crisis of the late 1990s, portfolios were riskier, loan losses higher and returns lower than they are at present, but it did not adversely affect their institutional credit ratings due to state backing.[2] The EBRD argued it was able to weather the impact of a major shock 3.5 times the size of the global financial crisis triggered by the Asian financial crisis, using only accumulated reserves[2].

However, it does appear that DFIs were lowering their expose to risk during the period leading up to the 2008 global financial crisis, capital adequacy ratios were increasing, bad loan reserves decreasing and portfolio shares in Africa were unstable[2]. The IFC's loan loss reserves fell from 21.9% of the total loan portfolio in 2002 to 8.3% in 2006, and EBRD’s from 12% in 1999 to 2% currently[2]. The share of sub-Saharan Africa in IFC’s portfolio was only 10.7% in both 2001 and 2007[2]. Policies seeking to buck this trend involved changing staff remuneration policies[2]. For example, the IFC introduced a remuneration process that links salary awards not only to volume but also to the development impact of past investments[2]. This could lead to greater financial risk, but greater development effectiveness[2]. Research by the FMO suggests that projects with a high development impact produce higher rates of return[2]. The DEG rewards projects with good development ratings[2].

2008 Global Financial Crisis

DFIs, however, cannot take on more risk without paying heed to accessibility of credit in the wider international financial markets[2]. However, DFIs are less directly affected by the 2008 global financial crisis, because of their mainly fixed rate loans and high levels of liquidity[2]. DFIs could thus play an important role in being the lender who is not only the ‘first to enter’ a market, but also the ‘last to leave’[2]. This may reduce the problems caused by herding behaviour of private capital flows[2].

References

  1. ^ Andrea Levere, Bill Schweke, and Beadsie Woo, Development Finance and Regional Economic Development, Washington, DC: CFED, July 2006
  2. ^ a b c d e f g h i j k l m n o p q r s t u v w x y z aa ab ac ad ae af ag ah ai aj ak al am an ao ap Dirk Willem te Velde and Michael Warner (2007) Use of subsidies by Development Finance Institutions in the infrastructure sector Overseas Development Institute

finance development is to support development activities in a certain country

See also


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