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Aron Betru
Managing Director, Center for Financial Markets
Africa and Capital Access and Emerging and Frontier Markets and Finance and Financial Innovations and FinTech and Impact Investing and Sustainable Development
Aron Betru is managing director of the Center for Financial Markets at the Milken Institute, where he leads strategic initiatives focused on expanding and leveraging resources to enhance social impact. Prior to joining the Institute, Betru was co-founder and CEO of Financing for Development, where he pioneered ways to leverage...
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Clearing a Path for Action: Enabling Basel and Development Guarantees to Deliver on Sustainable Development Goals

By: Aron Betru
June 12, 2017
   
   

“Unfortunately, we can’t offer you a reduced interest rate despite the U.S. government guarantee you’ve secured.”

Believe it or not, these are the words that international development professionals often hear when they attempt to negotiate innovative/blended financing transaction with a bank, hoping that having a guarantee from some bilateral or multilateral donor will make the bank comfortable enough to finance a road, hospital, or agricultural equipment to fuel development in an emerging market. It is not that the bank would refuse to do the deal; on the contrary, doing a transaction with reputable players and governments is exactly what they want. However, they are not likely to lower the cost of financing (interest rates) based on just a guaranteeeven if it’s from the U.S. government.

How can that be? How is it possible that financing backed by a “guarantee” from the U.S. government’s Development Credit Authority, Swedish SIDA, or the Gates Foundation is no less expensive than financing without a guarantee? Surely, a guarantee from a G20 country or a multi-billion dollar foundation should lower the risk/cost of financing, shouldn’t it?

Unfortunately, it’s not that simple. In fact, it’s revealing to look at the complexities and constraints the bankers must contend with when supporting development initiatives. From that perspective, the truth is not all guarantees are the same. The value of a guarantee depends not only on the guarantor, the size, and the financial transaction it covers, but also on the international financial regulations that govern the fine print.

Although some guarantees are written to take the first loss unconditionally, some are either conditional on a range of issues or partial in what they cover. Effectively, from a bank’s perspective, if the guarantee requires either considerable work or time to file a claim, and/or it is uncertain that conditions for repayment will ever be met (for instance if there is a chance that the commitment to be paid back will be rejected due to minor issues), then it’s not that helpful. It is not really a “guarantee.” According to the Bank of International Settlements (BIS) in Switzerland, these banks are right.

The BIS’ Basel Committee is instrumental in formulating a series (Basel I, II, and III) of global financial regulatory accords for supervision and risk management of banks. A regulator in a member country has the ability to ratify the standards (usually with few modifications), but once that is done, a bank that wants to operate in that country has to abide by that standard. Banks that accept deposits must determine the amount of capital they need to keep in reserve based on Basel III liquidity guidelines. Banks that lend must determine the amount of capital required based on a delicate dance of risk weightings and leverage ratios, all governed by Basel III guidelines.

Unfortunately, for most investors, providing capital to developing countries means investing in the riskiest markets, and in such instances, investing requires some risk mitigation or enhancement to get a deal done. For banking institutions that leverage a development guarantee, if that guarantee is not unconditional, they do not consider it true credit enhancementor, more appropriately, it is a risk share rather than a risk transfer (from the bank to the guarantor). If a bank has to share every dollar lost pro rata (proportionally), it is sharing risk. Effectively, it is not improving the credit worthiness of a borrower (a developing country or social enterprise), but rather reducing the dollars at risk. When a financial institution reduces its exposure like this, the risk is proportionally the same; just fewer dollars are at risk. Thus, the cost of financing is the same as it would be without the guarantee.

In addition to the certainty of a guarantee, the attachment point (when it covers a loss) also matters. In the event of a loss, several scenarios are possible, ranging from minor partial loss to complete loss. Conditions that lead to total loss are very rare (either blatant theft or catastrophic acts of nature). Often the value lost in a loan or investment is substantially smaller, with investors or banks recouping something. With these more common types of partial loss, a guarantee that is first in line to cover a few dollars is more valuable than one that covers a lot, but is second or third in line. Ultimately, guarantees that are not clear on their certainty (conditionality) of covering a loss or that are secondary or tertiary in their attachment (wherein the line they stand for covering losses) are not as effective in mobilizing private capital in a meaningful way.

This is critical now because the international development community is changing its approach to financing development. The Millennium Development Goals (MDGs), which expired in 2015, principally financed development activity through government- and foundation-donor grants and other concessional financing. But for the past two years, and in line with the post-2015 Financing for Development Agenda, donors have been scrambling for ways to mobilize domestic and private-sector dollars to support the 17 objectives of the United Nation’s new Sustainable Development Goals (SDGs).

Launched in September 2015, spearheaded by the United Nations, and agreed to by the 193 member countries, the SDGs aim to transform our world for the better with laudable goals such as ending poverty, improving education and equality, as well as fostering peace, justice, and strong institutions. Under the new financing strategy, the private sector is seen as integral to providing jobs, income, housing, and health services, with donor dollars not being responsible for all the financing but rather becoming co-investment carrots.

Although a number of countries have signed pledges (going back decades) to contribute 0.7 percent of their Gross National Income toward foreign aid, this is not enough. Unfortunately, current estimates are that there is more than a $4 trillion financing gap to meet the SDGs.

However, under the guidelines of the Organization for Economic Cooperation and Development (OECD), a mere guarantee commitment does not qualify as part of that 0.7 percent foreign aid pledge. Effectively, providing a $100 million guarantee (that might never be called) does not give that donor country the same kudos as giving a straight $1M grant. The OECD is working on new metrics to capture such innovative financing approaches, however, the 0.7 percent pledge still focuses on traditional foreign aid. Regardless of the development impact or magnitude of investment mobilized, donors thus remain incentivized to engage in simple transfers rather than leveraged investments that can mobilize more capital, and potentially be more effective in achieving the SDGs.

Clearly, any modality that looks to blend public and private capital to meet SDG targets is critical. As such, calls have been made for private capital that can blend in innovative ways to augment public or donor funds. Currently, there are a number of such efforts: guarantees, credit enhancements, commitment agreements, and program-related investments built on a theory of change rooted in facilitating an investor/bank’s first taste of developing country risk with the hope of that investor/bank’s sustained future involvement. However, in most cases, structuring such guarantees that plan for development impact in the future misses the point that there is not enough capital today, and that perhaps flexibility in providing better guarantees is required. Again, not all guarantees are the same. The effectiveness of these vehicles is not uniform given the variability in the certainty they provide, and at what point in the line they stand in covering potential losses as well as the theory of change they were built on. This makes it harder for private investors to step into the developing markets that SDG targets focus on.

Global stakeholders must understand that in addition to just asking private capital to invest, development practitioners should be thinking about policies and practices that de-risk investments in SDG objectives. There are ways of standardizing guarantee language, or creating guarantee funds that work better to capitalize aligned banks or even Basel reform all with an eye toward improving ways of de-risking investments in developing countries.

  1. SDG Guarantee Standardization – Unfortunately, not all guarantees are the same; some are written in a way that become difficult for banks to benefit from the credit enhancements, and as such, still have high cost of capital. There is value in thinking about standardizing an approach from donors (i.e. aligning contractual terms and conditions) to maximize risk-weighting (IFC Bonds have had success here) and the certainty of the guarantee. There is also value in thinking about how to standardize the compliance requirements to reduce the opportunity cost.
  2. SDG Guarantee Fund – Given that donors do not get as much recognition for guarantees, they do not have as much incentive in supporting such efforts. Perhaps there is room for a vehicle/program that could receive the grants from the donors (allow them to get the 0.7 percent foreign aid credit) and aggregate the capital; but then, go even further than normal guarantees by actually providing equity to financial institutions to enhance their assets (like the U.S. government’s Troubled Asset Relief Program (TARP) and its various iterations) with a requirement to prioritize financing to SDG investments. It is worth noting that TARP, while greatly criticized, in the end had a large positive return for the U.S. government.
  3. Basel Reform – Given that financial regulations govern how guarantees and other credit enhancements are treated by banks, we should look to develop new policy recommendations on Basel III could enable greater incentives to invest with SDG objectives. Could there be appetite to have SDG Guarantees from G20 countries (AAA rated) being exempt from the paid in capital test (remain unfunded) but still have banks benefit from it?

Each of these options comes with a different set of tradeoffs, between going farther versus getting there faster versus doing things more sustainably. Each option comes with different incentives for different stakeholdersBIS, banks, regulators, donors, private investors, and developing country governments and their populations. As the policy discourse on financial regulations (all over the world, especially in the U.S.) heats up, let’s not forget that these policies could have unintended consequences for countries and their people.

Fortunately, the countries that drive policy within the Basel Committee are the same ones engaged in forming international development aid rules, and they are all looking for waysincluding via mechanisms like GAVI Alliance and Global Fundto make their donor dollars go farther. Another good piece of fortune is there are many people in the international banking community who genuinely want to help. The complexity of an admittedly complicated ecosystem, or our unwillingness to do the hard work of grinding through the details, cannot get in the way of good intentions and available resources. Let’s elevate our thinking, adopt a more systems-based and results-oriented approach, and seize the opportunity to nudge private-sector players to work with developing countries to improve the lives of their citizens.