Development Banks in Time of Great Volatility

The pendulum between markets and governments has gone back and forth over the past decades. When I became a professional eonomist, it was the tail end of the Washington Consensus era, with a focus on market-based solutions and governments focusing on providing the institutional and macroeconomic framework. One controversial part of this Consensus was the role of state-owned banks and, more specifically, development finance institutions (DFI). Often set up with the help of the World Bank in the 1960s and 70s, they developed mostly a rather dismal track record (one of my colleague commented on the 80% plus NPL ratio of one African agricultural DFI rather cynically, “why would they not make the extra effort to get to 100%?"). Political interference was ripe (one African finance minister in the same country commented to me once that the cotton farmers in his district really depended on the agricultural DFI for funding; on the way out a local colleague told that there were no cotton farmers in his district ☹).

But pure reliance on market forces has not really helped address many of the failings we observe in developing countries, partly because there are market failures and the challenge is to develop markets rather than to purely rely on them. This has also opened a new role for DFIs, not so much in retail lending but in second-tier activities – on-lending.  Almost 20 years ago, my former World Bank colleagues Augusto de la Torre and Sergio Schmukler framed the concept of the visible hand of the government, with tools that include partial credit guarantees, platforms to match small supplier with financiers and large buyers, and start-up subsidies for new market segments. Public-private partnerships in infrastructure financing has become the state-of-the art approach, even though the devil is in the detail.

DFIs might also have a counter-cyclical role.  Bank lending is procyclical and typically retrenches most when you need it most, i.e., during recessions and crises.  The obvious trade-off is macroeconomic stabilization through DFI (or more broadly state-owned bank) lending and risk of  resource misallocation.

Late last year, we organised an on-line workshop with Oliver Wyman to discuss some of these issues, with representatives from different multinational, regional and national development banks.  The event was under Chatham House rule, but here are some highlights:   While the economic outlook is somewhat better now in February than back in December, the current macroeconomic environment poses major challenges for SME, while governments have limited fiscal space and monetary tightening will make funding conditions even harder and commercial banks more reluctant to lend. That is where DFIs can come in!  However, it is hard to reach out directly to SMEs, and might be better to do so through targeted credit lines through commercial banks (if funding constraints are binding) or credit guarantees (if risk premiums are a binding constraint). Beyond access to funding there is also the challenge of formality in many developing countries. The IDB Lab has deployed a combination of grants and advisory services to support innovative ventures that help address the informal sector, such as digital payment solutions.

Going forward, climate change and transition to net zero will be a challenge, especially for SMEs.  This will also be relevant for the focus of DFIs. For example, the Brazilian development bank BNDES is to shift the organization’s focus from purely financial value creation to one of positive socio-environmental impact.

Finally, let me mention that together with some colleagues at the FBF, we are currently working on a project with the IDB advising the new government of Colombia on how to strengthen DFIs in Colombia, drawing on examples of other countries, in the areas of financial inclusion, innovation and sustainable finance.  More to come…