MDBs Should be Credit Enhancer Rather than Lenders

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Today, there are some estimates of the climate funding needs for African projects of some $3 trillion by 2030. There is also the view that this funding can be harnessed from institutional investors if the investments were “de-risked”. Therefore, the search is on to fund such de-risking.

So the question is raised: how much de-risking capital is needed? A back of the envelop number is ~ $750 billion as we see below (about 25%).

No Free Lunch and No Investment Without Risk

In practice, “de-risking investment” is an oxymoron as there is no investment without risk. While risks can be parsed, allocated and mitigated, they simply cannot be eliminated. So a more productive focus is on risk segmentation and allocation. One can allocate the higher risks to those willing to take such risks and investment grade risks to those who prefer higher credit quality.

Multilateral Developments Banks (MDBs) are a Natural Source of Risk Capital

In 2005, I recommended at a World Economic Forum event that given MDB’s excellent asset quality on loans and guarantees, they should leverage their guarantees up to four to one (versus one to one on loans). Under this idea, MDBs would have an incentive to promote guarantees, which currently account for a trifling share of their activities. This is still a good idea.

MDBs’ development related assets (mainly loans) total some $1.5 trillion (see S&P’s Supranationals Special Edition of October 2021). MDBs deploy capital mostly to make loans, not book guarantees. As such, MDB leverage is below one, limited by their statutes. Even the largest MDB guarantor, MIGA, has a gross outstanding guaranteed exposure of $23 billion, with a net exposure (after reinsurance) of less than a half: $9.1 billion (see its 2021 Annual Report).

If MDBs were to issue substantially more guarantees instead of loans, they could increase institutional investment attracted by such risk mitigation to a multiple of what MDBs currently lend on their own balance sheets. But this would take a new mindset: MDBs would become the providers of risk capital to the private sector instead of being lenders, as they are now.

MDBs Should Originate to Distribute as Aggregators – Room2Run Shows the Way

MDBs and their partners should move to an “originate to distribute” model as they benefit from preferred creditor status. They can exploit this to attract institutional investors. African Development Bank has already shown the way. Its Room2Run transaction in 2019 pooled and securitized a portfolio of 50 loans from 25 African countries. The total of all credit enhancements was 27.25%. This means that loans of MDBs in Africa (which individually might be rated CCC to B) can be bundled into an investment grade (BBB or higher) package on a portfolio basis, with about one dollar in risk mitigation to four in lending.

Individual Deal Guarantees are Too Costly but Offer Another Way

On individual transactions, the level of risk mitigation is typically much higher and the risk reduction much smaller than for Room2Run type diversified loan pools.

For example, to upgrade a single transaction from a Baa3/ BBB- rating to a Baa1/BBB+ rating (a two-notch upgrade), one needs credit enhancement of about 53%. A similar calculation shows that 37% credit enhancement is needed for a one-notch upgrade. These calculations I did in 2020 apply rating agency default and recovery statistics to expected loss at different rating levels.

The calculations are consistent with a 40% IDA guarantee Ghana used on its $1 billion bonds in 2015, which achieved a two-notch rating upgrade from Ghana’s standalone rating then: to B1 from Moody’s and BB- from Fitch.