TRADE, FINANCE AND INVESTMENT COMPETITIVENESS FINANCE EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT Literature Review and Framework for Institutional Investor Mobilization Charles M. Kahn Anderson Caputo Silva Gonzalo Martinez Torres © 2023 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. 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Cover photo: iStock metamorworks >>> Contents ACKNOWLEDGEMENTS 6 ACRONYMS 7 EXECUTIVE SUMMARY 8 BACKGROUND: PROJECT ON ROLE OF DFIs IN INSTITUTIONAL 11 INVESTOR MOBILIZATION INTRODUCTION: THE COMPONENTS OF THE ANALYSIS 12 CHAPTER 1: LITERATURE REGARDING THE ENCOURAGEMENT OF 15 INSTITUTIONAL INVESTMENT CHAPTER 2: DISTINCTIVENESS OF INSTITUTIONAL INVESTORS 18 2.1 Difference in Needs of Pension Funds and Insurance 18 Companies as Compared to Banks 2.2 Differences within Pension Funds and Insurance Companies 19 and Relevance to Their Potential as Investment Partners 2.2.1 Domestic/International Institutions 20 2.2.2 Large/Small Institutions 20 2.2.3 Life Insurers (including Annuity Providers) versus Property and 20 Casualty Insurers 2.2.4 Defined Benefit versus Defined Contribution Pension Plans 20 2.2.5 Varying Regulatory Restrictions and Social Mandates 21 CHAPTER 3: ROLE OF INCENTIVES 23 3.1 Incentive Problems for Efficient Government Investment 23 Decisions 3.1.1 Short-Term Thinking 23 3.1.2 Hold-Up 24 >>> Contents 3.2 Incentive Problems for MDBs 25 CHAPTER 4: THE HIERARCHY 27 4.1 Top Level: Sustainable, Profitable Investments; Danger of 28 Crowding-Out 4.2 Second Level: Investments in Need of Catalyst; Sustainable 28 Once Initial Frictions Overcome 4.2.1 Increasing Pipelines 29 4.2.2 Standardization 29 4.2.3 Development of Financial Infrastructure 30 4.3 Third Level: Financing with Concessional Terms 31 4.4 Fourth Level: Full Public Funding 31 4.5 Fifth Level: Ineffective Investments 31 CHAPTER 5: TYPOLOGY OF MDB AND DFI ACTIVITIES 33 5.1 Actions Common to MDBs and For-Profit Financial 33 Intermediaries 5.1.1 Initiation 34 5.1.2 Project Collection and Selection 34 5.1.3 Structuring Products 34 5.1.4 Investing and Financial Commitment 35 5.1.5 Monitoring 36 5.2 Actions Unique to the MDBs 36 5.2.1 Subsidizer 36 >>> Contents 5.2.2 Government Adviser 37 5.2.3 Guarantor of Reputation 38 CHAPTER 6: CONCLUSION 39 6.1 The Context 39 6.2 Hypotheses 41 6.2.1 Scalability 41 6.2.2 Standardization 41 6.2.3 Initiation 41 6.3 Tactical Issues 42 6.3.1 The Whole-Life-Cycle Approach 42 6.3.2 Approach-Based Activities Versus Individual Transactions Based 42 Activities 6.4 Implications for the MDB Role 43 REFERENCES 44 >>> Acknowledgments This study was authored by Charles M. Kahn (consultant), Anderson Caputo Silva (World Bank) and Gonzalo Martinez Torres (World Bank), under the guidance of Jean Pesme (Global Director, Finance, Competitiveness and Innovation Global Practice, World Bank) and Bill Maloney (Chief Economist, Equitable Growth, Finance and Institutions, World Bank). The study has benefited from the support of the Joint Capital Market Program (J-CAP) – Sustainable Finance Facility (SFF) funded by the Swiss Confederation through the State Secretariat for Economic Affairs (SECO). The authors benefited from the kind advice provided by peer reviewers Jordan Z. Schwartz and Laila Nordine (both World Bank) and by Issa Faye (IFC) on behalf of the Sector Economics and Development Impact department in IFC. Valuable inputs were also received from Catiana Garcia- Kilroy, Fiona Stewart, Simon Walley, Olivier Vidal, and Ana Carvajal (all Long-Term Finance, FCI, World Bank). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 6 >>> Acronymns CIF Caribbean Investment Facility DAC Development Assistance Committee (OECD) DFI Development Finance Institution EMDE Emerging Market and Developing Economies EME Emerging Market Economy ESG Environmental, Social and Governance GDP Gross Domestic Product IBRD International Bank for Reconstruction and Development IDA International Development Association IFC International Finance Corporation IIM Institutional Investor Mobilization IMF International Monetary Fund LAC Latin America and Caribbean LIC Low-income Country MCPP Managed Co-Lending Portfolio Program MDB Multilateral Investment Bank MIGA Multilateral Investment Guarantee Agency NPV Net Present Value OECD Organisation for Economic Co-operation and Development PCM Private Capital Mobilization PIF Public Infrastructure Fund PINAI Philippine Investment Alliance for Infrastructure PPP Public-Private Partnership SME Small and Medium Enterprise WB World Bank WBG World Bank Group EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 7 >>> Executive Summary Institutional Investor Mobilization (IIM) is key to achieving the United Nations (UN) Sustainable Development Goals (SDGs), which require investments of trillions of dollars per year. By contrast, the annual lending capacity of the Multilateral Development Banks (MDBs) and other Development Finance Institutions (DFIs) amounts to US$350-400 billion per year. Banks have reduced their lending for development since the global financial crisis of 2008. Meanwhile, the potential for increasing funding from institutional investors is enormous. Indeed, such investors control US$70 trillion of funds in developed markets, but only US$5 trillion in emerging markets. Institutional investors’ participation is constrained by well-known barriers to development finance, including legislative and regulatory restrictions, as well as the inadequacy of domestic financial scale and financial infrastructure. However effective actions also require an understanding of the needs and incentives of various categories of institutional investors, as well as of the governmental incentives that may also pose a barrier to development finance. Finally, it is important to take into account the potential mismatch of incentives within the structures of the MDBs themselves. The current interest in Environment, Social and Governance (ESG) investing provides an important example of opportunities for the use of MDBs’ powers to crowd in new classes of institutional investors. Specifically, the MDBs are able to connect investors with ESG opportunities in developing markets. Importantly, the MDBS are also able to bring the standards of ESG reporting and monitoring up to the levels required by those investors. Investment in EMDEs has natural attractions for institutional investors. However, progress to date is limited. The existing literature offers little guidance about the effectiveness of different MDB approaches to unlock these investments. The development of a framework that accounts for the distinctiveness of institutional investors and for incentives faced by governments and MDBs requires resorting to the wider literature in finance and economics. In this regard, the findings in the theoretical literature concerning financial intermediation, incentives and contracting, liquidity, dynamic investment, and research and development are of particular importance. The wider conceptual investigation shows that effective IIM requires a readjustment in the orientation of the MDBs. The comparative advantages of the MDBs in their relationships with institutional investors are different from their comparative advantages in more familiar relationships with banks. Most institutional investors require some degree of intermediation in order to participate in development finance. Thus, the MDBs play a hybrid role, acting both as EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 8 financial intermediaries, and as institutions with public policy individual institutions. The MDBs are a natural location for goals. Relative to for-profit institutions generally, the MDBs platforms, but there are also gains from working with large, have advantages in developing trust between governments for-profit financial institutions. These larger institutions and private institutions, as well as in increasing governments’ have the greatest capacity to draw in new clientele and abilities to commit to long-run beneficial behaviors and to attractively structure their offerings. It is important to policies. However, relative to institutional investors in take into consideration the difference in the objectives. particular, the MDBs’ important strengths are their credibility However, the complementary skills of the MDBs and as evaluators of credit quality of projects and investments— for-profit asset managers offer the greatest potential for skills that may have been relatively less important when scaling up institutional investments. dealing with experienced banking institutions. ● Standardization: In achieving scalability in crowding- A proposed framework for mobilization of institutional in private investment, standardization is an essential investors and implications tool. Some of the most valuable innovations involve the development of replicable arrangements for missing Socially desirable investment projects can be classified markets, for example, in mortgage finance or insurance, according to the following hierarchy: thereby reducing the barriers for institutional investors. The successful development of such arrangements 1. Investments that are profitable and sustainable for private has generally required cooperation between the MDBs, participants. governments and private institutions. Platforms are also 2. Investments requiring systematic catalysts, but no valuable for providing standardized products to some individual subsidy. types of private institutional investors. 3. Investments amenable to private participation, but requiring public and/or concessional resources. ● Initiation: The power of MDB-initiated approaches is 4. Investments fundable only through governments or DFIs. associated in part with their willingness to surrender the concepts to the private sector — once their feasibility The most effective way of facilitating MDB support of has been demonstrated. The duplicability and potential institutional investor mobilization is to focus on catalyzation contestability of an approach by competitors makes it efforts and maximizing the crowding-in of private investments more difficult for the for-profit institutions to experiment. (categories 2 and 3 above). In the context of Maximizing By contrast, the MDBs place a priority on developing Finance for Development (MFD), the activities of MDBs can infrastructure to the point where they can stand without be classified as “transactions-based” activities, focusing further MDB assistance. on individual investments, or “approach-based” activities, focusing on the development of capacity and the creation of The theoretical arguments imply the following tactical new markets. At either level, it is important to understand the considerations for DFIs, as they attempt to support institutional circumstances in which these activities will be more effective investor mobilization: in the hands of the MDBs, where they are best left to for-profit intermediaries, and where there is a potential for interaction. ● Whole-life-cycle approaches as a response to institutional diversity: Because different classes of Building on basic theoretical principles, the following institutional investors differ so greatly in their tastes for hypotheses are proposed:1 financial assets, achieving scale in long-term financing is likely to require arrangements that bring in a mixture ● Scalability: The logic of the hierarchy implies an of investors, including banks, as well as variety of increased focus on both platform development and international and domestic institutional investors. For this engagement with large intermediaries rather than with reason, whole-life-cycle approaches are important, taking 1. The accompanying papers in the institutional investor mobilization study examine the effectiveness of various programs for mobilization in particular sectors. A chapeau paper will complete the study. It will reflect on the extent to which the general hypotheses proposed here are relevant in the two sectors examined, that is, housing finance and infrastructure finance. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 9 into account from the outset the transfer of risks among ● A MDB advisory role as an essential function: The investors over the course of a project. The MDBs are in traditional advisory role of the MDBs is even more critical in a good position to organize and participate in investment the context of institutional investor mobilization. This is due programs using a whole-life-cycle approach. However, to the heterogeneity of institutional investors and the wide caution must be exercised to ensure that their involvement range of enabling environment reforms typically required. at too many stages does not dilute the reputation of the MDB for objective analysis and evaluation. ● Strengthening central-local product development capabilities: The product development capabilities ● Centrality of approach-based activities: Almost by needed to mobilize institutional investment will likely definition, approach-based activities have the greatest require greater coordination between the headquarters potential for crowding-in at scale, since they focus on a of the MDBs and the specialists in the field. Whereas range of projects at once. However, they require focus on “top-down” activities focus on reaching overall MFD product development capabilities, as well as on the capacity goals, local developers will need to tailor elements to to build partnerships, as previously noted. Furthermore, the specific contexts across countries and strategic their risks are greater, and their effectiveness is much sectors. Meanwhile, the attention to scale and replicability harder to evaluate than that of individual transaction- becomes the responsibility of all stakeholders. based activities. The difficulties in measuring results are a challenge when the MDBs attempt to provide accurate ● Relevance of DFI partnerships: The multitude of incentives and guidance within the organization. For this essential roles that the DFIs play to support institutional reason, careful studies documenting the results of these investor mobilization — from advisory to enhancement and activities are of central importance to the MDBs. Indeed, co-investment functions — calls for collaboration among they are necessary to determine the correct allocation of the DFIs with complementary roles. The geographic reach resources among the different types of programs. of the DFIs is also critical for scalable solutions involving many countries and regions. Partnerships with regional ● Complementarity of transaction-based activities: and national DFIs are relevant, even to the MDBs, such Nonetheless, transaction-based activities have an as the World Bank Group (WBG). Indeed, the WBG offers important role to play in reaching scalability. They are the global coverage and a wide range of services through the laboratories for testing or demonstrating the effectiveness combination of its constituent parts, including the World of proposed new approaches, as well as for determining Bank (WB), International Finance Corporation (IFC) and the replicability of approaches in new countries and the Multilateral Investment Guarantee Agency (MIGA). sectors. This understanding implies a difference in focus. Specifically, it means that, from the start, the potentials ● Rewarding initiation: As presented, the MDBs have the for scalability and replication need to be considered in ability to initiate approaches that would not otherwise individual transactions. They should also be included in the be developed and tested by the for-profit institutions. metrics for assessing success. Finally, this difference in These approaches have the potential to unlock private focus also has organizational implications as noted below. investments on a larger scale, particularly from institutional investors. Incentives for fostering initiation must be The proposed framework is based on the hypotheses and ingrained in the MDBs’ activities, with support flowing tactical considerations presented. As such, it brings concrete, from the top management to the implementing teams. practical implications as to how the MDBs could be more effective in facilitating institutional investor mobilization. The four main implications are as follows: EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 10 >>> BACKGROUND: PROJECT ON ROLE OF DFIs IN INSTITUTIONAL INVESTOR MOBILIZATION This “Literature Review and Framework for Mobilization of Financing from Institutional Investors” is part of a wider project conducted by the World Bank Group to examine the effectiveness of activities undertaken by the MDBs to encourage private institutional investment. The other papers in this project are examining examples in two specific sectors, namely: infrastructure finance (Garcia-Kilroy and others, 2023) and housing finance (Walley and Vidal, 2023) with particular attention being paid to sustainable finance. The current paper begins with a review of the theoretical and econometric literature regarding the use of the MDBs to crowd in private investment. The existing literature is limited and focuses heavily on infrastructure finance. Such focus ignores the importance of other investment sectors for development. It may also bias an understanding of the possibilities for mobilization across those sectors. Therefore, the rest of the paper uses the more general theoretical literature in finance and economics concerning incentives and intermediation to establish a framework, as well as to develop some basic hypotheses regarding the encouragement of institutional investment. The framework and hypotheses are designed to be applicable to the investigation of other sectors as well, thus establishing the types of intervention in which the MDBs could have comparative advantages. In addition, they address the approaches that could have the greatest impact, including the specific roles that the MDBs would play in enhancing mobilization of institutional investor capital to various sectors. This document is primarily targeted to the staff of the World Bank Group, both at the global and regional levels. As such, it seeks effective approaches and actions to enhance institutional investor mobilization. The document should also be useful to other MDBs and government counterparts contemplating how to best leverage MDB activities to attract private investments. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 11 >>> INTRODUCTION: THE COMPONENTS OF THE ANALYSIS Achieving many of the UN’s Sustainable Development Goals requires investments at scale.2 Such investments can only be reached by increasing the mobilization of private capital.3 The lack of long-term financing is one of the primary challenges facing developing economies. Accordingly, the World Bank Group’s Maximizing Finance for Development (MFD) approach is designed to help governments crowd-in the private sector to help meet development goals.4 Although private sources already provide most of the lending to emerging and developing countries, efforts to increase institutional investor mobilization (IIM) by the World Bank Group and other multilateral development banks (including European development finance institutions) have met with mixed success.5 In the short term, the COVID-19 pandemic has brought many investment sectors to a standstill (World Bank Group 2020c), but the longer term is also a concern. Banks are a traditionally important provider of capital. However, they have become an increasingly problematic source, given the tightening of regulatory and risk standards. A promising alternative source is other institutional investors—in particular, insurance companies and pension funds. In some respects, institutional investors6 are ideal participants in development investments. Many institutional investors have a natural demand for long-term investments and a large supply of capital for investments of suitable characteristics, provided suitable instruments are available. Both domestic and foreign institutions are potential investors. Investment can occur either directly through the participation by the institutional investor or indirectly through financial intermediaries collecting institutional funds and then directing their ultimate allocation. Participation can also occur directly through capital injection or indirectly through insurance arrangements. 2. Estimates range into the trillions of dollars per year (McKinsey 2016; World Bank Group undated-b). The World Bank estimates that the needs of the infrastructure sector alone approach one trillion a year (Rozenberg and Fay 2018). 3. Private mobilization refers to investments carried out by entities that are established for business purposes. They are financially and managerially autonomous from local or national governments. They are divided into “direct mobilization,” whereby a MDB’s active and direct involvement has led to the private commitment, and “indirect mobilization,” which occurs when private financing is provided “in connection with a specific activity for which a MDB is providing financing, where no MDB is playing an active or direct role that leads to the commitment of the private entity’s finance.” (IFC 2018, page 13). 4. See (World Bank Group undated-b). 5. See (World Bank Group 2020a) for an estimate of progress in meeting targets. 6. The term “institutional investor” can include entities such as sovereign wealth funds, endowments, foundations, family offices, pension funds, and insurance companies. This paper focuses on targeting insurance companies and pension funds. However, most of the analysis will apply more generally. In particular, investment funds will also play an important role in the process. Thus, some of the examples in this paper will also consider sovereign wealth funds. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 12 Presumably, there are a large number of EMDE investments credit guarantee for an infrastructure project (“transactions- that would be profitable for institutional investors to fund, based activities”), and those that focus on the development and an even larger number of socially desirable investments of capacity or the ability to deal simultaneously with multiple for which concessional financing arrangements would be projects, such as through regulatory regime adjustments or the appropriate and attractive to institutional investors.7 Thus, development of new institutional financing arrangements and the first question is: “What are the barriers?” Why are the markets (that is, approach-based activities). The distinction amounts invested not already much larger? Also, what can is not precise: frequently transaction-based activities also MDBs do to increase the flows from institutional investors? In include a demonstration aspect, proving the feasibility of general, provided there are indeed attractive opportunities, the new approach for future use. In this case, potential the barriers can be classified as problems of (i) legislative and sustainability of the approach becomes a key consideration in regulatory restrictions; (ii) insufficient inventory of projects evaluating the activity. that have been brought to the bankable stage; (iii) a lack of investment infrastructure; and (iv) incentives. Special In both transactions-based and approach-based activities, attention will be paid here to particular incentive issues that a MBD or DFI plays a hybrid role, acting both as a financial have sometimes been underappreciated. institution and as a public institution charged with public policy goals. For some activities, such as the broadest levels Conceptually it is useful to classify projects according to the of research and advice to governments concerning policy following hierarchy: reforms or the development and subsidization of programs for ESG investment, involvement stems from the special 1. Investments that are profitable and sustainable for private public mandate of the MDBs. However, many other functions participants. overlap with the activities carried out by for-profit international 2. Investments requiring systematic catalysts, but no financial intermediaries (investment funds, asset managers), individual subsidy. that is, institutions in the business of collecting funds from 3. Investments amenable to private participation, but savers and directing them to suitable investments. Most requiring public and/or concessional resources. institutional investors will desire some degree of intermediation 4. Investments fundable only through governments or DFIs. when engaging in development finance. Thus, in analyzing the situations in which MDB activity is most effective, it is (Below these four there is, a level 5, that is, investments that important to take into consideration the reasons that private would not achieve satisfactory social returns and so should financial institutions are not carrying out these activities. not be funded at all.) Under MFD, the goal of the MDBs is to Consideration should also be given to determining the special find activities that can mobilize private capital in categories skills or powers that the MDBs bring to the work. 2 and 3 above, while also minimizing MDB involvement with participation at levels 1 and 4 (and 5).8 Effective action requires This paper begins with a review of the empirical and theoretical understanding the incentives of the institutional investors, as literature concerning the ability of DFIs to encourage private well as of governments and the MDBs themselves, including investment in EMDEs. Both empirical and theoretical results how the activities modify those incentives.9 suffer from extremely limited granularity, having little to say about what kinds of MDB actions may be most effective. The activities of the MDBs can be usefully divided into those Furthermore, they tend to concentrate on a limited set of that focus on the individual investment or project, such as a investment sectors. Therefore, using more general theoretical 8. However, this assumption should not go unchallenged. The framework and the sector-by-sector examinations presented here will also keep in mind that there are some7sectors where better intermediation can unlock the supply of capital, whereas with other sectors, entirely different considerations are at play. In particular, these concern investments that deserve funding based on equity or on their public good nature, even if these investments cannot yield a competitive rate of return. In addition, some risks, notably exchange rate risks, may provide enormous barriers to private attempts to provide risk management. 8. Our hierarchy is inspired by the “cascade” concept initially developed by the WBG to address the barriers faced in development investing, while cognizant of the need to prioritize their activities to optimally utilize scarce public resources, both financial and personnel. Although the concepts have similarities, the purposes to which they are put are distinct. The main objective of the cascade approach is to optimize the use of scarce resources as borrowers; the source of the financing (public or private) is only considered after the prioritization is established. 9. While this paper focuses on the best methods for mobilizing institutional investor capital for individual projects and programs, it is also important to remember that gov- ernments and MDBs must have a broader view of the problem. Governments are concerned not just with funding projects in isolation, but also with the consequences of capital mobilization in terms of the country’s overall financial position. For example, governments facing debt sustainability challenges may confront a trade-off between having a MDB co-finance or guarantee specific projects and using the MDB’s credit enhancement to improve their financing terms when issuing bonds to cover general expenses. As the MDBs can only provide limited exposure to any given country, an overarching government borrowing strategy is critical to support decisions regarding how to best crowd in institutional investor capital, while also minimizing overall financing costs and risks for the government. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 13 arguments from economics and finance, a framework is built, in which the question can be addressed across sectors more broadly. The factors that distinguish institutional investors, such as pension funds and insurance companies from banks, are examined as a source of development lending. Then, the role of incentives as a barrier to greater participation by institutional investors is considered. Finally, the investment hierarchy is used to develop a typology of the interventions that DFIs have engaged in as part of their efforts to attract institutional investors. Based on the theoretical literature, some simple implications are provided to measure the comparative effectiveness of various activities. The approach implies that greater emphasis be given to partnering with large-scale intermediaries, in order to achieve scale in crowding-in institutional investors. A variety of examples of standardization are provided, both in terms of institutions and instruments that also reap economies of scale. An argument is presented that the MDBs have an important advantage in innovating because they are able to bear the up-front costs and risks without concern if the profits from the innovation are eventually contested away by competitors. At the tactical level, life-cycle approaches to investment are valuable, given the diversity of institutional investors and the differences in their risk and liquidity preferences. Careful evaluation of incentives within the MDBs is necessary in order to balance transactions-based activities with potentially important, but difficult-to-document approach-based activities. The rest of the project on the role of DFI’s for institutional investor mobilization focuses on examining the effectiveness of these activities in practice in two particular sectors, namely, infrastructure finance and housing finance. The study will also provide a foundation for future investigation of other sectors also deserving mobilization of institutional investor finance, such as Small and Medium Enterprises (SMEs). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 14 1. >>> CHAPTER 1: LITERATURE REGARDING THE ENCOURAGEMENT OF INSTITUTIONAL INVESTMENT10 The World Bank Group and its development partners have adopted a Private Capital Mobilization (PCM) framework, described in its Maximizing Finance for Development agenda. Mobilization is carried out through two broad approaches: 1. Advising clients and working with investors and partners; and 2. Deploying mobilization instruments and platforms. Among the instruments and platforms are arrangements for debt and equity syndication, co-lending initiatives, and credit enhancement programs. Empirical work concerning the effects of MDBs in encouraging institutional investment is extremely limited.11 The World Bank Group (2020a) provides aggregated numbers (see also Inderest 2021 for a summary). Figures ultimately come from (MDB Joint 2019; 2021) or from the Organisation for Economic Co-operation and Development (OECD). Inderest, for example, emphasizes that private capital co-financing is small relative to the gross domestic product (GDP) figures of borrowing countries or to estimates of climate and SDG goals. In 2019, the MDBs mobilized US$63.6 billion of private finance in operations in middle- and low-income countries, far short of the trillions needed. (World Bank Group 2020a).12 Climate- related finance has risen dramatically, but totals are still small. From the OECD figures, Inderest concludes that guarantees are the dominant mobilization instrument in lower income countries. Blended finance, in the sense of including a third–party concessional element, is also limited. It generates about US$3 billion per year, mobilized from commercial sources.13 With rare exceptions, scaling does not occur. Institutional investor involvement in public-private partnerships (PPPs) remains minuscule. 10. This chapter focuses on empirical and theoretical literature that specifically examines the effort of the MDBs to crowd in institutional investment funds. Relevant contri- butions concerning broader topics are noted and dealt with throughout the paper. 11. An important reason for the limited econometric work is the heterogeneity of approaches used by the MDBs for crowding in private finance. Because of this, there is a particular value in an organized examination of cases within various sectors, as laid out in the separate papers covering the housing and infrastructure sectors. In con- trast, there is a large but very broad theoretical literature concerning more general topics related to the encouragement of institutional investment, such as the relative strengths of the MDBs and the needs and differences of institutional investors and governments. These will also be relevant to developing the framework. Rather than duplicating this material in the literature review, the relevant papers will be referred to as part of the exposition of the framework in subsequent sections. 12. While this amount represents an overall decline of 8 percent from 2018, it includes US$6.7 billion mobilized for low-income countries. This represents a significant in- crease of 21 percent. (MDB_Joint_2019; 2021). The International Bank for Reconstruction and Development (IBRD) met its G-20 mobilization target of US$5.9 billion in 2017. However, the volume fell to US$2.6 billion in 2019. The IFC’s core mobilization volume was US$7.5 billion in 2017 and US$10.2 billion in 2019. 13. This is the definition used in DFI (2020). Other, broader definitions are also in use. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 15 Econometric studies are even more limited, mostly focusing lending to emerging and developing countries during the period on International Monetary Fund (IMF) loans, and not easily 1994-2014. The paper develops indirect evidence of MDB generalizable to the MDBs. Erce and Riera-Crichton (2015) note activities encouraging investment by private lending. Lending that much of that portion of the literature finds no catalytic effect. in which MDBs participate is associated with greater borrowing However, using gross capital flows and distinguishing between costs than lending in which MDBs do not participate. However, domestic and international investors, the authors find that, while the authors argue that this can be explained by the MDB’s the IMF does not catalyze foreign investors, it does encourage willingness to finance projects that the private sector would not domestic investors to reduce capital flight and increase undertake alone.14 MDB lending is also associated with longer repatriation. Significantly, they document that the IMF’s longer- loan maturities. The authors include interaction terms in the term programs ( that is, the Extended Fund Facilities) have a regression, showing that MDB participation appears to reduce stronger ability to catalyze domestic savings. These programs spreads for riskier loans. They also note that MDB participation also entail a milder negative reaction by foreigners. is associated with smaller loans, thus serving as a caution against overreliance on them to increase the scope of lending. There are a limited number of studies at the macro level concerning the effect of MDB lending on capital inflows to Broccolini and others (2021) also uses loan-level data. a country. A study by Kharas and Shishido (1991) using a However, they delve more deeply into the sectoral level to structural model of credit rationing for a panel of developing estimate the mobilization effects directly. This appears to be countries with data up to 1985 finds evidence that official aid unique in terms of using loan-level data for such an econometric generated private capital flows during that period. In contrast, analysis. The study focuses on indirect effects, that is, the Rodrick (1995) provides what he describes as “crude” tests extent to which MDB participation in a loan correlates with of the question of whether multilateral lending predicts subsequent capital mobilization in that sector in that country subsequent private capital inflows and concludes that this is in lending, but without MDB participation. The study uses the not the case. Ratha (2001) reviews and critiques the mixed number of loans, the size of lending, the number of participating evidence in these and other earlier studies. Ratha provides banks, and the maturity of loans as measures of mobilization. time series evidence of two forms of complementarity between The authors find that on all dimensions of measurement, MDB lending and private investment: first, a countercyclicality MDB participation increases non-MDB syndicated lending between public and private short-term lending in the 1990s in in the next two years at levels which are significant both low-income countries; and second, a positive, albeit lagged economically and statistically. For example, they find that a response of private to public lending. The latter, he argues, country’s having at least one syndicated loan supported by could be indicative either of a signaling effect or of the ability a MDB in a sector in one year is associated with an increase of the MDBs to foster a better investment environment. The of nearly 2.5 syndicated loans in the next two years. For magnitudes are significant. For example, the share of a lower- robustness, they consider a variety of controls, including the middle-income country in private lending over the medium possibility of anticipation of MDB participation, the effects of term (six years) rises nearly 1 percent following a 1 percent participation by major private banks, and/or other aid flows. rise in the share of multilateral lending. However, these figures vary greatly over subsets of countries, as well as over methods The Broccolini and others paper (2021) also considers of scaling to adjust for relative size of country. the potential direct effects of MDB participation, that is, the possibility that private investors participate because the MDB Relying on syndicated lending data, a few papers provide presence improves the conditions of the loan in question, indirect evidence of MDB activities encouraging investment specifically through risk mitigation, including the sharing of by private lenders. Hainz and Kleimeier (2012) use loan-level preferred creditor status, as well as information sharing. They data from 1996 to 2005. It shows that MDBs are more likely show that both direct and indirect effects are likely to be at to participate in syndicated project finance loans when political play. As a further robustness check, the authors examine risks are high. They are also particularly likely to participate as corporate bond issuance in a subset of the countries. They risks become very high. In a more detailed study, Gurara and conclude that there is no evidence of MDB activity crowding others (2020) use loan-level data on cross-border syndicated out the bond sector. In addition, they do they find evidence of 14. The conclusion requires the assumption that spreads reflect econometrically unobserved borrower risk. The analysis for the most part does not distinguish between the returns of the MBDs and the private participants within the syndication. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 16 MDB participation in one sector crowding out lending in other Although most of the literature does not explicitly consider sectors of the country. Indeed, if anything, the evidence favors the MDBs, the role of expertise can be thought of as implicitly the possibility of spillovers. They subdivide the countries to rationalizing their inclusion in PPPs. Arekzi and others (2017) show that the marginal effects of MDBs are greater in less provide an informal model of the MDBs as providing a “gate- risky, richer, and more financially developed countries. keeping” role in infrastructure finance, thereby validating the projects at the beginning of the process. However, this role is Thus, there is evidence that at least some kinds of MDB limited by insufficient capital of their own to finance the projects. activities encourage private sector crowding in. However, to Thus, they propose rethinking the PPPs in an originate-and- answer the question of which choices by the MDBs are most distribute framework, in which MDBs would act as third-party effective at bringing in institutional investment, empirical work monitors, thus giving their imprimatur to approved projects, as at a more granular level would be needed. What is available well as passing them along to institutional investors. instead is a set of capital multipliers (also called leverage or mobilization ratios). These are estimated for various The same theme is provided in the model of Rodrik (1995). investment projects or funds. However, the inconsistency of He argues that the skills of the MDBs are in gathering definition and method limit the ability to make comparisons information and in “conditionality” (that is, enforcing behaviors of these across institutions. It should be noted though that on governments) rather than in lending per se. However, ongoing development of systematic standards is occurring the lending may be a necessary component to align MDB (DAC 2020). Moreover, for proper comparisons, they will incentives. Noting the limitations of the effectiveness of need to be adjusted for instruments used and differences in conditionality in practice, Hagen (2009) instead considers investors. Riskiness of projects, sectors and countries should the incentives of international agencies to provide accurate also be taken into consideration (Inderest 2021). reports to private lenders. Providing advice without lending on its own may be sufficient if the agency places a high enough Theoretical work concerning the crowding in of investment value on the success of the private loans that rely on its advice. is also limited. However, there are some theoretical papers However, having the agency play a lending role as well can that have examined the possible roles that MDBs can play in make the information provision more effective. encouraging private investment. Not all of the work on PPPs has argued for efficiency benefits. Hainz and Kleimeier (2006) develops a financial contracting While acknowledging the economic rationales, Engel and model applicable to development lending. The model involves others (2020) argue that the main reason governments have two-sided moral hazard. Specifically, the success of the project chosen PPPs for infrastructure projects is as a way of evading depends on efforts of both borrower and lender. In the model, fiscal constraints and budgetary controls. Maskin and Tirole the use of project finance becomes increasingly likely with (2008) model the use of PPPs to avoid budgetary constraints. increased political risk. Under the hypothesis that MDBs act as “political umbrellas,” the model predicts a complementarity In sum, there are a limited number of papers that provide between MDB participation in the syndicate and the use of arguments as to the mechanisms through which the MDBs project finance. This model underlies the empirical work in might be able to encourage private investment. These papers Hainz and Kleimeier (2012) described earlier. also provide little guidance as to circumstances in which one or another technique is likely to be most effective. For this The theoretical literature concerning PPPs emphasizes the reason, in the remainder of this paper, the wider theoretical incentives that the project finance structure provides when literature in finance and economics will be utilized to provide responsibilities and powers are divided between governments general guidance. In particular, findings in the theoretical and private agents. In addition to providing an overview, literature concerning financial intermediation, incentives and Iossa and Martimort (2015) examine the usefulness of contracting, liquidity, dynamic investment, and research and partnerships under asymmetric information, moral hazard, development, will be noted as they become appropriate. and renegotiation. They point to the need for expertise on the part of private lenders in order to enhance the value of bundling planning and implementation. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 17 2. >>> CHAPTER 2: DISTINCTIVENESS OF INSTITUTIONAL INVESTORS Although international banks have traditionally been major financiers of private-sector projects in developing countries, their cross-border activities have become more conservative and short term since the global financial crisis of 2008. For example, the World Bank’s 2018 Global Financial Development Report states that the international banks’ claims on emerging markets were at 50 percent of their pre-crisis level (IFC 2018). In most countries, the domestic banks lack the capacity to address financing needs.15 Institutional investors (including insurance companies and pension funds), sovereign wealth funds and mutual funds have an enormous capacity for investment. A growing, but still small portion, of those funds are currently being invested in emerging markets.16 Thus, for these institutional investors, the possibility to enter a new investing sector — largely uncorrelated with the risks they typically handle — is a naturally tempting opportunity for diversification. In addition, infrastructure assets may provide an inflation hedge when payments are correlated with inflation. However, without adjustments of approach new institutional investors may have limited appetite for co-financing the kinds of investments in which the WBG engages. 2.1 Difference in Needs of Pension Funds and Insurance Companies as Compared to Banks Because of the nature of their liabilities, insurance companies and pension funds in general are receptive to long-term investments.17 Infrastructure projects, for example, typically need financing at terms of at least 10 years, and sometimes as much as 25 years. This contrasts in particular with the financial structure of banks, whose source of funding is often comprised of largely short- term, liquid liabilities. Maturity mismatch is the fundamental problem that banks encounter.18 As a result, safety considerations skew them toward shorter term, more liquid investments. 15. For example, in Latin America (Garcia and Rudolph 2017, p. 35), provide a rough estimate that meeting infrastructure funding gaps would require more than 40 percent of several countries domestic banking assets, and would be a challenge for all the countries in the region. Large infrastructure projects would hit concentration limits for domestic banks. 16. IFC (2018) estimates that institutional investors control US$70 trillion of funds in developed markets, and they hold under US$5 trillion in assets in emerging markets. In the Latin America and Caribbean (LAC) region, for example, commercial banks provided nearly 40 percent of capital for infrastructure projects in the years 2011-2015, that is, more than double that provided by development banks. By contrast, pension funds provided less than 3 percent, and sovereign funds and insurance companies even less. (Garcia and Rudolph 2017, p. 30). In its survey of development infrastructure projects, the World Bank Group (2020c) found that in the first half of 2019, 28 percent was debt finance from institutional sources. This was greater than the amount from commercial sources (commercial bank lending on commercial terms). However, these results were highly skewed by a single project in Mexico. 17. Differences in investment appetite within these institutional categories are noted below. 18. The theoretical justification for maturity mismatch is a basic theme of the banking literature, beginning with the lenders’ underlying preference for liquidity. For a simple exposition see, Diamond (2007). For an example regarding the use of short-term liabilities as an incentive to encourage bank monitoring, see Calomiris and Kahn (1991). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 18 Compared with banks, insurance companies and pension assessment and monitoring can be of benefit to newcomers funds generally have lower liquidity needs.19 In a low-interest in the arena. rate environment, they show a greater willingness to take on a variety of alternative investments, as well a readiness For example, infrastructure project finance in particular has to sacrifice liquidity for yield and stable cash flow. This is complex patterns of risk over the lifetime of the project. The important because it means that full-fledged, developed liquid risks differ between the preconstruction phase and the early capital markets may not be necessary to attract them. 20 years of construction, as well as throughout the lifetime of operation of the infrastructure. Early risks can be high, but they By far, the greatest amount of pension fund and insurance are short term in nature. Once up and running, operational company infrastructure investments have been channeled risks are long term, but lower. If initial lenders prefer short- through various kinds of infrastructure funds (Stevens and term arrangements, then they will value the ability to pass the Bond 2015). It has regularly been argued that the Basel III financing off to longer-term institutional investors; thus, there requirements also pose a restriction on the ability of banks can be important synergies between banks and pension funds to participate in projects, particularly those of a long tenor and/or insurance companies. (however, see also FSB 2018). Capital adequacy and liquidity requirements are fundamental to the regulation of banks Insurance companies, as experts in assessing unique risks, under Basel III standards. The more illiquid the assets in the are a natural source for providers of credit risk insurance portfolio, the greater are the capital requirements. Regulatory within a financing structure. For example, the IFC’s Credit requirements on other financial institutions also put in place Mobilization Initiative is designed to exploit this synergy similar restrictions on capital, liquidity, and portfolio standards. between insurance company expertise and emerging market The principles of macroprudential regulation cover all financial needs for products to insure credit risk exposure (IFC 2018). institutions regardless of category.21 Thus, regulation for systemic risk is intended to apply proportionately to bank and non-bank financial institutions. However, concerns regarding 2.2 Differences within Pension liquidity and financial stability in almost all jurisdictions are in fact more salient for banks. Because of the inherent instability Funds and Insurance Companies from maturity mismatch, and the systemic dangers that bank and Relevance to Their Potential as instability imposes on an economy, regulators tend to impose tighter standards for safety and liquidity on banks. This is the Investment Partners case even when a bank’s private calculations conclude that If the goal is to attract more pension funds and insurance returns justify the maturity mismatch risk.22 companies into investment in development projects, it is important to understand the variations within these categories Despite regulatory constraints, international banks still have of financial institutions. These variations lead to differences some important advantages when engaging in developing among institutional categories in terms of their tastes for risk economies. Their size, expertise and experience mean and tenor of investments. However, they lead to even wider that they will continue to play a central role, no matter variation in their willingness to participate in marketable how successful the attempts are at developing alternative versus non-marketable categories of investment, as well sources of private capital.23 Indeed, these advantages yield as intermediated versus direct forms of investment.24 It is important complementarities. Their work with domestic banks also important to understand potential interactions between in co-financing is a source of knowledge transfer in several various categories of institutional investors, which are likely to developing financial markets. Also, their experience in be important to the success of various techniques. 19. There are occasional exceptions. For example, insurance companies and pension funds have been subject to runs when customers lose confidence in their solvency. For examples, see Zonana and Kristof (1991). 20. On the other hand, liquidity stemming from standardization is still desirable for those institutions that have difficulties in evaluating non-standard instruments. Moreover, some liquidity is necessary for institutions whose customers have the power to switch from one provider to another, as in typical defined contribution plans (see below). 21. For an overview, see for example, Schoenmaker and Wierts (2011). For application to the EMDEs, see Krishnamurthy and Lee (2014). 22. Banks’ appetite for risk also depends on the competitive environment. As the local institutional investor base develops, it can provide a competitive spur to banks to move further down the credit spectrum. 23. For a quick summary of some of the typical skills of banks in lending to PPPs, see Stevens and Bond (2013, p.11). It also discusses how differences in institutional investor expertise create varying demand for guarantees. 24. For example, Shindo (2020) notes that US public pension funds often focus on infrastructure equity instruments, whereas insurance companies focus on infrastructure, thus showing more appetite for debt instruments. According to data from Preqin, an investment data company, infrastructure investment in 2019 was around 2 percent of assets under management for pension funds, less for insurance funds, but 6 percent for sovereign wealth funds. Their surveys also show greater interest in direct investing among insurance companies than among pension plans. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 19 2 . 2 .1 D O M E S T I C / I N T E R N AT I O N A L large insurance companies regularly have in-house asset management groups, which bring their own expertise to INSTITUTIONS investment decisions. Thus, they are motivated to engage in cooperative, exploratory investments in previously untapped Domestic institutions have advantages over foreign markets to develop their competencies and explore potential institutions in three important ways. First, they have local new growth sectors. However, large institutions may rely on knowledge.25 Second, they are less vulnerable to cross border scale economies in their investing programs. Therefore, they risk, particularly foreign exchange risk. Third, they may have may find that individual small projects or small markets do political clout to resist some forms of government repudiation not justify the costs of investing. Some specialized insurers of its contracts. Since all three of these considerations are can play a dual role in investments, providing both funding significant contributors to investment barriers, domestic and insurance services for investment vehicles. Another institutions are likely to be valuable partners when expanding potential model is illustrated by Swiss Re, which has provided the participation of institutional investors. Furthermore, insurance for some loans in IFC’s Managed Co-Lending domestic institutional investors have an important role to Portfolio Program (MCPP) (IFC 2021b). play in improving livelihoods in developing economies. For instance, when domestic institutional investors diversify away from short-term government assets into other domestic asset 2.2.3 LIFE INSURERS (INCLUDING classes such as listed corporate securities, they can help ANNUITY PROVIDERS) VERSUS mobilize domestic resources and grow domestic savings. P R O P E R T Y A N D C A S U A LT Y INSURERS Foreign institutions, particularly those with experience in multiple countries, have on occasion aided in transferring best Because of the long-term nature of their liabilities, insurance practices from one jurisdiction to another.26 For this reason, companies concentrate on the longer end of the maturity there can be complementarities between domestic and foreign spectrum. For instance, the majority of bonds purchased institutional investors in funding investment projects, beyond by life insurance companies have a maturity of greater than those due simply to differences in risk appetite27 Furthermore, 10 years at the time of purchase (ACLI 2020). However, the in any institutional sector, the domestic scale will be tiny as greater uncertainty regarding their payouts implies property compared to the international scale. Domestic financing and casualty firms have a greater need for assets that can accounts for more than half of infrastructure financing in be liquidated at a low cost (Saunders 2008). For instance, middle-income countries (McKinsey 2016 p. 21). Furthermore, whereas US insurers invest primarily in bonds, the second when it comes to financing by insurance companies Shindo most important category for property and casualty insurers is (2020) notes the rarity of countries in the “sweet spot,” that common stock, and the second most important category for is, those places where the domestic sector is large enough to life insurers is mortgage loans (III 2021). make a difference in the country’s infrastructure gap. 2.2.4 DEFINED BENEFIT VERSUS 2.2.2 LARGE/SMALL INSTITUTIONS DEFINED CONTRIBUTION PENSION PLANS The size of individual institutions is also an important distinguishing factor. Small institutions (for example, pension The customers of pension funds are interested in financing funds in small economies or single-employer plans) may their long-term needs. Thus, at first glance it would appear the find it impossible to make some kinds of specialized foreign pension funds would focus on long-term returns. However, it investments on their own (CEPA 2020). At the other extreme, 25. The WBG (2020a) emphasizes the importance of domestic investor participation to the success of programs it reviewed. 26. Garcia-Kilroy and Rudolph (2017, p. 28) argue for the benefits that can arise from knowledge transfer by international banks in project risk assessment and monitoring in the LAC region. 27. Garcia-Kilroy and others (2023, p. 66) describe the case of CKD Infrastructure Mexico, a Co-Investment Platform between a Global Investor, Domestic Pension Funds, and a Domestic Infrastructure Fund (FONADIN) in Local Currency. Caisse de Dépôt et Placement du Québec (CDPQ), a global institutional investor, joined a consortium of five Mexican investors, including the National Infrastructure Fund (FONADIN), the public pension fund (Pensionisste), and the three largest private pension funds. They worked to invest in the platform. This platform has allowed the Mexican investors to benefit and learn from CDPQ’s infrastructure investment expertise. In exchange, the CDPQ has gained local intelligence, deal access and, probably, some political risk protection. The platform has invested more than US$1.65 billion (83 percent of the US$2 billion raised capital) in road, telecommunications, and renewable energy projects. The platform has an investment horizon of 50 years. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 20 is important to distinguish between the situations of defined to defined contribution arrangements, this preference poses benefit and defined contribution funds. In a defined benefit an increased challenge for economies with less developed plan, the pension manager has a fixed, predictable long- securities markets. term obligation. As such, the manager is induced to choose investments which provide the largest long-term returns. In this respect, the situation is similar to that faced by a life 2 . 2 . 5 VA RY I N G R E G U L AT O RY insurance company. Under a defined contribution regime, RESTRICTIONS AND SOCIAL customers evaluate plans according to their performance. M A N D AT E S Since they are generally able to switch their accumulations from one plan to another, they perforce make their evaluations Regulatory authorities are often willing to adapt regulations of over a short-term horizon relative to their lifetime needs. Thus, financial institutions to new circumstances. Nonetheless, there the pension manager is judged by the returns gained year-by- is great variability in regulation across jurisdictions, as well as year, and in particular by the returns relative to those amassed across classes of institutional investors within jurisdictions. by competing defined contribution plans. In this respect, the These differences can affect the ability of institutions to engage situation of the defined contribution pension fund most closely in some categories of investment. Thus, attempts to bring in resembles that of a mutual fund. new classes of institutional investors requires an awareness of existing restrictions. In an ideal financial market, the tension between short- and long- run calculations does not create a bias in investment choices Different regulatory environments place various constraints by fund managers. Savers would optimize their portfolios by on debt versus equity investment or on the proportions of a dynamic strategy, switching over the course of their working investment-grade assets required in a portfolio. Different lives among long- and short-term portfolios with different risks, regulators place a different urgency on investing funds as returns are realized and wealth changes. Nonetheless immediately (such as, when short-term large supplies are savers would evaluate the performance of portfolios relative to provided from a change over from defined benefit to defined a benchmark that considers the term structure of the portfolio contribution schemes). Many countries’ regulations restrict and their own patterns of lifetime consumption demand.28 pension fund investments to listed instruments or investments However, in practice, investors cannot observe the details satisfying equivalent public disclosure requirements. Often of the term structure of the investment. Therefore, they are regulatory restrictions regarding defined contribution programs constrained to rely on the observed, short-term returns to the mimic restrictions on retail fund managers, with limits on portfolio as a proxy for the skill of the portfolio manager. This exposures to related parties or maximum holdings of particular information asymmetry induces the manger to focus on short- issues. They also typically mandate participants’ rights to term returns rather than on the more appropriate objectives.29 switch pension providers. Such a mandate encourages competition. However, it may distort investment incentives Even more important, the ability of customers to switch (see previous subsection). from one fund to another requires defined contribution plans to hold a larger portion of their assets in marketable An extreme example of regulatory differences arises with securities. Reinforcing this tendency, the most talented publicly owned funds, which may have political and social portfolio managers will prefer to allocate funds to investment mandates different from those that regulators impose on categories in which returns (and thus skill) are most easily comparable private institutions. Notable among these are observed. Again, this leads defined contribution plans to show the mandates for ESG investing. Currently, there is enormous a relative preference for listed securities, where prices in deep growth in ESG investing, and institutional investors are a large markets provide easily-observed signals of performance.30 As part of the growth. Some institutional investors have decided pension plans throughout the world move from defined benefit that increasing their portfolio of green and sustainable 28. For the distinction between myopic and optimal long-run investment decisions, see for example Campbell and Viceira (2002). Rudolph and Sabat (2016) provide guid- ance on developing pension appropriate benchmarks. 29. See Shleifer and Vishny (1997). For a recent parallel application to hedge fund management see Linnainmaa and Moreira (2018). 30. For a dynamic example of choice of degree of signaling by a financial institution, see Heinsalu (2018). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 21 investments makes financial or reputational sense, despite the additional risks often imposed by technological and regulatory uncertainties. (McKinsey 2016). Throughout the world, regulatory and policy decisions influence which classes of institutions engage in ESG investing. For example, Norway’s Sovereign Wealth Fund has a track record of investment in green bonds and other vehicles to support sustainable infrastructure. It has been argued that, worldwide, pension funds are the principal driver of corporate governance reforms. For instance, Japan uses its Government Pension Investment Fund to help develop best governance practices in investments in which they participate. As such, they use ESG indices for tracking and establishing stewardship responsibilities for their external asset managers (World Bank Group 2018). In the US, public pension funds in particular are at the forefront of ESG investing.31 Regulation plays a key role in determining participation in ESG investing. Virtually no institutional ESG assets are held by private sector defined benefit plans, reflecting the US Department of Labor’s interpretation of regulations defining pension funds’ duties of loyalty and prudence. State and local plans are not covered by these regulations. Most state plans and a significant portion of local plans have either ESG policies or state mandates for social investing.32 31. According to USSIF (2020), public funds in the US hold the majority of the institutional investor ESG assets. 32. See Aubry and others (2020). Of course, ESG investment is not without controversy. Small, specialized investment funds opposed to the ESG approach have recently arisen, hoping to court pension funds in conservative-leaning states in the US (McCormick 2021). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 22 3. >>> CHAPTER 3: ROLE OF INCENTIVES Incentive problems are a large part of the barrier to development finance. The policy decision to expand the participation of institutional investors in development financing exacerbates many of them. In the previous section, a variety of incentives issues were laid out, including those that are distinctive to different kinds of institutional investors. When MDBs structure products and platforms, it is important to take these incentives into consideration. How this can occur is examined further in section 5. In the present section, the incentive issues affecting other participants are considered. The focus is on the incentives of the governments of the countries seeking to borrow and, not least, the multilateral agencies themselves. Are there potential mismatches between the goals of these agencies and those of the institutional investors? Perhaps MDB goals had been better aligned to an earlier business model focusing on bank financing and direct financing. If so, what adjustments are desirable to reorient MDB attention to different institutions? What adjustments are needed to improve the alignment of goals?33 3.1 Incentive Problems for Efficient Government Investment Decisions 3 .1 .1 S H O RT-T E R M T H I N K I N G For governments, the fundamental incentive problem that drives a wedge between public objectives and incentives is short-term thinking, which in turn stems from the fact that the time horizons of the agents carrying out the policies are necessarily shorter than those of the public interest. This is true for elected officials who are dependent on political cycles and political exigencies. It is also true for appointed government officials whose career paths are still limited relative to the long-term horizons of development goals. Short-term thinking leads to the temptation to front-load the benefits of investment projects and bury the costs where they cannot be found until later.34 Some forms of private sector financing of public sector infrastructure are politically tempting because they apparently enable 33. Attention is focused on changes in MDBs and government behavior to bring them into alignment with institutional objectives, although occasionally the remedy may be an investment mandate enforced upon local institutions themselves. 34. An extreme example is “white elephant” investments, whose main benefit is their initial prestige. An analogous problem arises when political considerations prevent charging end users for infrastructure services. (Garcia-Kilroy and others, 2023, p. 72). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 23 investment without affecting the country’s fiscal balance. For short-term bias. For example, by combining project financing example, contingent guarantees by government entities may and operations, PPPs can enable more efficient project choice, be disguised in official accounts until they come due, often at reduced costs of construction, and better maintenance. a time beyond the horizon of the political decision maker. As However, these economic advantages only accrue if the noted in the literature review section, PPPs may be used as a parties to the PPP can commit to its terms. The power of these politically expedient evasion of fiscal constraints. arrangements is restricted by the possibility of hold-up (that is, the repudiation at a later date) by either party. In practice, a One remedy for the temptation to miscount financing costs is hold-up by the government takes the form of unilateral policy to include the total amount of the PPP on the government’s changes, whereas a hold-up against the government takes balance sheet at the inception of the contract. In contrast, the the form of strategic behavior in a renegotiation.36 rules of Eurostat, for example, mandate inclusion or exclusion depending on the existence of government guarantees as A renegotiation of PPPs is routine (Engel and others 2020, p. part of the arrangement (Engel and others 2020). Along the 20). Garcia and Rudolph (2017, p. 26) cite figures showing that same lines, it is argued that public infrastructure funds can the majority of PPPs in Latin America and Caribbean (LAC) potentially reduce this temptation if they consolidate all PPP countries are renegotiated. When agreements are complex activity into a single location for ring fencing and managing and long-term, renegotiation is an inevitable consequence of total risk (World Bank Group 2020b), as well as develop a unexpected developments. Nor is it necessarily inefficient coherent strategy for choosing among potential investment to renegotiate. For example, the parties to the arrangement projects. However, for such a fund to be effective in these must weigh the costs of renegotiation versus the costs of goals, transparent and autonomous governance is necessary. working out all the consequences in unlikely contingencies, as well as including in their initial agreement, costly up-front Adding to the difficulties of dealing with government short-term negotiations concerning remote consequences. However, thinking are the complications of measuring long-term costs renegotiation opens the possibility for strategic manipulation and benefits. An approach, such as the Eurostat approach, of terms and activities.37 requires measuring the significance of the long-term risks imposed by contingent liabilities. As such, it is vulnerable In the case of either hold-up or strategic renegotiation, the to manipulation. In reference to government guarantees in efficiency losses arise from the inability of the parties to the financial arrangements, Irwin (2007) argues that successful agreement to rely on the behavior of the other parties, and subsidy proposals “tend to have opaque costs and to come this leads to their unwillingness to take otherwise desirable with a rationale explaining how they are good for the country actions that would leave them vulnerable. For example, the and don’t merely redistribute value. Proposals for guarantees threat of hold-up or strategic renegotiation leads parties to can meet these criteria, especially when the government’s receive revenues prematurely and push costs back too far. accounting and budgeting fail to recognize their costs. Counterparties in an investment have to worry whether the They come with plausible rationales about risk sharing, and compensation will be paid or the benefits received when the taxpayers are unlikely to understand the costs.”35 appropriate time arises.38 If concessionaires anticipate being bailed out if problems occur, then they no longer have the 3.1.2 HOLD-UP incentive to act efficiently. In addition, the process selects for politically powerful firms skilled in renegotiation rather than for When the benefits are capturable, for example, through project the most economically efficient firms.39 user fees, then private finance can help offset government 33. Attention is focused on changes in MDBs and government behavior to bring them into alignment with institutional objectives, although occasionally the remedy may be an investment mandate enforced upon local institutions themselves. 34. An extreme example is “white elephant” investments, whose main benefit is their initial prestige. An analogous problem arises when political considerations prevent charging end users for infrastructure services. (Garcia-Kilroy and others, 2023, p. 72). 35. Irwin also outlines some of the complexities in properly budgeting and accounting for the risk of government guarantees (Irwin 2007, Chapter 6). 36. According to Engel and others (2020, p. 21) “…while in principle renegotiations may allow governments to expropriate concessionaires after they have sunk their invest- ments, in practice it seems that the private partner benefits the most…” 37. For early models of strategic renegotiation with incomplete contracts, see Hart and Moore (1988) and Huberman and Kahn (1988). (Hart 2003) applies the model of incomplete contracts to public-private partnerships. 38. On the other hand, private counterparties’ fear of hold-up by the government does help mitigate the short-termism problem. A private counterparty will hesitate to enter a contract in which benefits are too greatly back- loaded, for fear that debts will not be honored at that point. Thus, the counterparty will be less willing to collude in con- cealing costs until a later date. 39. Engel and others (2020 p. 8) also cite evidence for renegotiation of terms being associated with government corruption. The article also describes a model in which strategic renegotiation enables a government to transfer costs to future administrations. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 24 Hold-up is always a problem in lending, but it is particularly important task, but one whose full benefits will not be reaped acute when a party to a loan is a sovereign government, until much later— indeed, even later than the outcome of the partially immune to legal restrictions. Public projects are initial individual projects themselves. subject to political risk from a government unexpectedly: (i) changing the rules that control particular prices; (ii) altering In the meanwhile, the problem is compounded by the difficulty quality standards; (iii) expropriating without compensation; or of measuring today the value of those future outcomes and (iv) altering taxes or subsidies.40 Structures for encouraging making them as salient as the immediate figures on the MDB institutional investment must carefully take into account design balance sheet. Available proxies inevitably lead to distortion. considerations to minimize the hold-up problem. In this respect, In the MDBs, employees and programs receive credit for the public infrastructure funds can also help provide credibility, volume, speed and ease of implementation of successful since they focus the responsibility on a single organization, investments they are seen to fund. Mileposts of success thus developing relationships and trust with creditors. Without include the signing of agreements, the initiation of investment such a focus, the original government agency may not even be activity, and timely revenue receipts and/or loan repayments. a party to later projects, thus suffering no consequences from Because of the limits of measurement, the MDBs understand reneging on agreements (World Bank Group 2016). More the need to engage in a continual process of long-term generally, one part of a government may sometimes serve as program review (for example, World Bank Group, 2020a). a break on abuses by another part (for example, in the case of local versus national jurisdictions), or an independent judiciary The incentive problems facing the MDBs increase the may take on this role. Finally, local institutional investors may difficulties of attracting institutional investors. The types of help to diminish temptations for hold-up, since a government projects for which participation of institutional investors is most may think twice before suffering the political costs that would desirable are themselves long run in nature. Moreover, the arise, for example, from failure to repay a local pension fund. attempt to attract such investors is also a long-run endeavor, requiring much coordination among various agents. For this Often the most effective protection against hold-up is the threat reason, the MDBs put great efforts into attempting to measure of the loss of future cooperation. Thus, an extra benefit arises the amounts mobilized from private sources in development when MDBs crowd-in private investment. Increasing the value finance interventions. The interaction between the MDBs of future relationships for all parties reduces the temptation for in jointly sponsoring a financial intervention leads to subtle short-term holdup. Subsequent sections further consider the incentive problems. The OECD Development Assistance role of MDBs in reducing hold-up. Committee (DAC) (2020) illustrates some of the practical difficulties in attributing the amounts mobilized from private sources in development finance interventions. For example, 3.2 Incentive Problems for MDBs this can include comparing the relative contributions of the MDBs that provide guarantees and those that provide capital or allocating attribution when there is a delay between The MDBs also have incentive problems. The objectives of a the MDB’s contribution and the private sector’s response. MDB are complex and the tradeoffs among them are subtle. It When the MDBs provide guarantees against different risks, is sometimes difficult to translate these objectives into effective it becomes difficult to determine their relative importance in inducements or guidance for those working for or directing the attracting private sector participation. Sometimes an MDB’s MDBs.41 Many of the most important development objectives overall reputation is an important factor in mobilizing private are of a long-term nature. The social benefits of infrastructure participation. When no explicit risk has been shouldered by projects accrue long after the employees of the MDB have the MDB, it is even more difficult to determine its relative designed and shepherded them through their initial stages. contribution to the mobilization. The establishment of markets and infrastructure for dealing with a country’s investment requirements is an enormously 40. See Irwin (2007, p. 87), which provides evidence of the importance of policy risk in infrastructure projects in developing countries. 41. The discussion and responses in the World Bank Group Approaches (2020a) lays out the difficulties of adjusting incentives in a complex MDB. The agency problem is also relevant for private, for-profit institutions, but less so, because these institutions have fewer constraints in terms of calibrating their employees’ rewards in order to align their incentives to the firm’s ultimate goal of profit maximization. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 25 Beyond these complications, there is a limit to the usefulness of notionally crediting the MDBs with shares of the funding crowded in, because the most important benefits of bringing in particular institutional investors may be those that spill over to later projects. The World Bank Group (2020a) highlights the imprecision of the link between the success of an individual investment and its effectiveness as a demonstration project. A more direct incentive problem arises from the interaction between a government and multiple MDBs. If one of the jobs of the MDBs is to curb inefficient government actions and reduce hold-up, then effectiveness will be limited by the ability of a government to play one MDB off against another — with the attendant threat of exclusion from further work in the target country.42 Yet another important case of the interaction between incentives of MDBs and governments arises in the analysis of debt sustainability. For example, the WBG and the IMF require debt sustainability analyses in order “to support efforts by [low-income countries] LICs to achieve their development goals while minimizing the risk that they experience debt distress” (IMF 2018). Both governments and MDBs are interested in properly balancing the burden of unsustainable debt against development goals, but the two parties will often place different weights on the risks involved. The framework and methodology for calculating debt sustainability levels is of use both to the borrowing LIC and to the MDBs. Therefore, the analysis can help both parties better understand the risks involved. Nonetheless, the effects on measured debt sustainability levels poses an additional constraint on borrowing countries because of the consequences for their ability to raise capital. In addition, the particulars of the required calculations may distort incentives for or against particular programs or methods of finance. 42. For an example of the pressure that arises when the DFIs compete for limited investment opportunities, see Edwards (2019). Humphrey and Michaelowa (2013) provide evidence of developing countries exercising preferences for one or another MDB. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 26 4. >>> CHAPTER 4: THE HIERARCHY Whether the investment being considered is a green infrastructure project or programs for housing finance, the investment problem faced by the country is ultimately a problem of adjusting for externalities. Any development investment has both an attachable component and a non- attachable (a general externality or a public good) component. Any investment for which the total of the two components’ net present value (NPV) is positive using the social discount rate is one which ought to be financed. Despite the increasing interest in ESG investing, and since private investors do not fully take into consideration the social benefits of investments, some worthwhile investments cannot be carried out by private entities alone. However, although the public entities (governments and MDBs) are concerned with both components of the investment, a number of factors prevent them from making the correct investment decisions in isolation. In addition to incentive issues, there is the problem of limits to public borrowing capacity. Domestic governments may not in fact be able to borrow at the social discount rate. Furthermore, the MDBs do not have the funding scale to take on all desirable projects. In either case, the attempts to scale up would prohibitively increase their cost of capital. For the purposes here, a hierarchy of socially desirable projects consists of the following categories:43 1. Projects that are already capable of standing alone for outside investors. 2. Projects that would be capable of standing alone, were it not for policy and regulatory gaps or weaknesses (including the limitations of the country’s financial or institutional infrastructure). 3. Projects that can benefit from private funding, but require public subsidy to be feasible. 4. Projects fundable only through governments or DFIs. 5. Projects whose social value is inadequate to justify funding. This hierarchy is used as a starting point for addressing the issues involved in increasing leverage from private sources. Nonetheless, it still has important limitations: 1. While in principle supporting a program or investment through regulatory reform may be superior to using subsidized funding, a mechanistic appeal to this prioritization will leave important projects unfunded while waiting for reforms to occur. 43. The hierarchy bears some similarities to the classification used in the MFD approach. When examining a project, the MFD approach argues for first determining if a private sector solution can be found. This can limit public debt and contingent liabilities. If not, the next step is to determine whether policy or regulatory gaps are the cause, in which case attention should be given to reform of these policies. If instead the lack of a private solution is due to a mismatch of risks, then the focus turns to whether WBG instruments can address these. Only after these steps should public funding be used. (Maximizing-Finance) EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 27 2. The hierarchy implicitly treats public and private funding success. Therefore, agents will have a bias to provide funding as substitutes, when they are sometimes complements. and attention to them. Correctly designating that a particular In some infrastructure projects, for example, public and project should be passed along instead to private investors will private funding will need to be combined in order to not give the MDB’s agents as much credit with their institutions align incentives. as would funding it themselves. 3. The hierarchy assumes that the ultimate motivating force is a limitation on, or a high cost of, government funding. Overzealous segregation of top-level projects or investments It will be ineffective if the government is uninterested may be counterproductive as well. For instance, there can be in redirecting its funding from marketable low-risk cases in which they may be justifiably bundled with the lower investments toward other needs.44 tiers. When scale economies are at issue (see the following 4. Finally, it must be kept in mind that maximizing the intake section), it may be necessary to bundle privately profitable of private finance is only one of the goals of a MDB. For investments in with lower tier investments to build an investment example, many projects in LICs are priorities — even if fund of useful size. More dubiously, such bundling could include they are never able to generate the same leverage as an element of cross-subsidy, thereby bringing an otherwise too- projects in emerging markets. risky portfolio of projects up to a commercially viable grade. When attempting to demonstrate the viability of a new approach or program, it may make sense to begin with projects that could 4.1 Top Level: Sustainable, Profitable otherwise stand on their own, as a “proof of concept.” While such practices could be justified, at the same time, they call Investments; Danger of Crowding-Out into question the sustainability of the program. Will it always be necessary to include such “sweeteners” in the mix in order to At the top of the hierarchy are investments whose capturable elicit the participation of private financial institutions? returns are already sufficient to attract profitmaximizing investors in the absence of any intervention. Using the MDB funds for projects that the private sector would otherwise have financed is generally an inefficient allocation of resources. 4.2 Second Level: Investments in Need While this phenomenon is usually described as the “crowding of Catalyst; Sustainable Once Initial out” of private investors, the welfare losses are in fact most Frictions Overcome closely tied to the limited capacity of the MDB relative to development needs—that is, to assure that limited government The second level of the hierarchy contains investments which and MDB resources are not wasted on them. would be adopted on their own except for the existence of systematic barriers. By working to eliminate these barriers, In contrast, some domestic DFIs have mandates that do not the MDBs serve as catalysts48 for investment. An important discourage the crowding out of private finance. Indeed, some set of systemic barriers arises from the legal and regulatory have mandates set by the government to target levels,45 environment and government incentives. For example, are which could lead to replacing private sector financing. This creditor protections in place? Is governance of local institutions is even more of a concern when the loans are based on satisfactory? Will the government honor its obligations? Is the subsidized financing.46 legal structure effective and independent enough to serve as a commitment device? The MDBs play a variety of roles in The instruction to MDBs to “not fund privately viable projects” reducing these barriers. sounds straightforward in principle. However, it is complicated not only by the difficulties of predicting private sector choices, In addition, many systemic barriers can be interpreted as a but also by incentives on the MDBs.47 The programs in lack of scale economies. Economics has long recognized this top class are most likely to hit measurable mileposts of the importance of specialization for reducing costs. In 44. If alternative uses entail riskier outcomes, a government entity flush with funds may require that the MDB offer, not funding, but insurance as an inducement to switch away from category 1 investments. 45. Garcia and Rudolph (2017, p. 84) cite Mexico and Brazil as examples. 46. For an example, see Frischtak and others (2017). 47. This point marks a distinction from the basic model of Cordella (2018), which assumes an elastic supply of funds from the public sector. Thus, there would be no social cost when MDB funds are used for investments for which the private sector is equally well equipped. 48. World Bank Group Approaches (2020, p. 11) distinguishes the more general notion of “catalyzation,” stemming from advisory work and policy reforms, from the more specific process of capital “mobilization” in which the WBG actively leverages the funds of a particular client through financing or guarantees. In practice the boundary is vague. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 28 addition, highly developed financial markets rely on a variety 4 . 2 . 2 S TA N D A R D I Z AT I O N of specialized skills. In smaller markets, the ability to exploit those specializations will be limited. As catalysts, the MDBs Standardization is an important way to reap economies work to overcome the fixed costs and exploit the scale of scale. Rather than learning procedures anew for each economies. Thus, eliminating a systematic barrier enables not transaction, the participant pays the learning costs once and just one, but a whole class of investments. The rest of this enjoys the benefits repeatedly. Many of the best practices section considers three categories of barriers for which MDB advocated or implemented by MDBs exploit standardization catalyzation is effective. of both investment opportunities and their presentation. For instance, the WBG guidance concerning PPP contractual 4.2.1 INCREASING PIPELINES provisions (World Bank Group 2019) is a force for the promotion of standardization of the terms and conditions of An often-repeated explanation for the lack of institutional investor these arrangements. A variety of international organizations participation in development finance is the absence of an have provided recommendations for adjusting PPP policy to adequate pipeline of investment opportunities (see, for example, move away from stand-alone transactions to standardized SwissRe 2020). It takes expertise for investors to be able to bidding, procurement documents, disclosure requirements, evaluate borrowers or projects and monitor their condition and and arbitration arrangements (SwissRe 2020). progress. At least part of that expertise relies on local knowledge. If there is not a large enough pipeline of potential financing The standardization of the financial terms is also valuable. opportunities, then it makes no sense for outside investors to put Standardized formats for investment instruments broaden their resources into developing such expertise. acceptability, reduce evaluation costs and bid-ask spreads. Thus, they increase liquidity. Standardizing the terms for For infrastructure projects in particular, the development guarantees and credit enhancements improves comparability, of the pipeline is a complex process. Project preparation thereby providing investors with a better understanding of the includes: (i) the identification of potential projects; (ii) planning comparative risks they are bearing (both across investments and preparing analyses of technical feasibility and funding and relative to other lenders within a complex investment).52 needs; and (iii) determining whether the project can be made compliant with regulatory and legal constraints, as well as A recurring component of standardization is the bundling environmental assessments.49 All of these must be provided of individual projects or investments together into a single in a timely manner. The resources it takes to do so can strain security, fund, or intermediary. This too is an exploitation of the capacity of developing economies and their governments. scale economies: it reduces the transactions costs associated with dealing with each project separately, thereby allowing The MDBs are able to meet these needs on several levels. large investors to acquire a portfolio of adequate size — or For individual projects in which they are investors, the MDBs allowing small investors to hold a diversified portfolio without already possess relevant expertise and information, the the costs of evaluating the individual components. sharing of which can make institutional investing profitable even at low levels of involvement. Individual MDBs house At an even broader level, the MDBs work to standardize Project Preparation Facilities50 that provide upstream project the classifications of investments across jurisdictions development, including planning, selection, design, as well internationally (for example, turning project bonds into a as the structuring of individual projects to add to the pipeline. recognized infrastructure asset class). Standardization of The MDBs also advise governments on developing capacity classifications facilitates securitization and makes it easier for and policies to improve their own project preparation; ease institutional investors to satisfy regulatory requirements with the burden on potential sponsors; and increase marketability regard to portfolio mix and quality.53 to potential investors.51 49. Detailed descriptions of the tasks can be found in, for example, World Bank Group (2020c). 50. They also cooperate with private institutions in partnerships, such as the Global Infrastructure Facility, to provide similar services. 51. For example, Garcia-Kilroy and others (2023) examines two cases focused on project preparation, Climate Investor 1 and IFC Infraventures. In the case of housing finance, see the example of Reall in Walley and Vidal (2023). 52. In particular, SwissRe (2020, p. 19) argues that the lack of standardization of MDB guarantees is a barrier to institutional investor participation in infrastructure finance. 53. Garcia-Kilroy and others (2023) consider cases with both sorts of standardization: transforming loans into investible assets through co-investment platforms (IFC- led MCPP) and project bonds that use credit enhancement to create standards, such as the Project Bond Credit Enhancement Facility (PBCE) implemented by the European Investment Bank. Walley and Vidal (2023) discusse the case of the Titularizadora Colombiana securitization platform in Colombia. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 29 4.2.3 DEVELOPMENT OF FINANCIAL or financial intermediaries. The tendency of local banks INFRASTRUCTURE in developing countries to stick to traditional guarantees and collateral arrangements rather than adopting the PPP Most institutional investors entering a new market will require a innovations for project finance, has limited local private large set of ancillary financial services. It is frequently claimed sector financing in infrastructure.56 To some degree, private that the inability to insure against currency risk is an important international financial institutions have responded to the barrier to institutional investors. Indeed, this has been the opportunity by expanding the financial market infrastructure. basis for arguments for international mechanisms to diversify Garcia and Rudolph (2017, p. 17) cite the example of Spanish such risk.54 Other pieces of the financial market infrastructure banks entering Latin American markets as intermediaries. that are likely to be important for less informed categories The banks raised funds through local bond issuance, and of institutional investors will be long-term government bond in turn used these funds for infrastructure finance. However, markets. These provide benchmark interest rates and facilities such arrangements generally require a fairly developed to deal with inflation risk, such as inflation-linked debt, or at a infrastructure at the start. minimum, reliable price indices. In some developing countries, the task of fostering Financial markets are subject to enormous economies of specialization is accomplished through “whole life cycle” scale. Scale significantly affects the liquidity of a market vehicles sponsored by the MDBs. An example in the case and its possibilities for diversification. Specialized services of green investments is the IFC’s one-stop shop called in complex financial markets, such as credit rating providers, Scaling Solar. It provides advice on project preparation, bid securitization facilitators, and information disseminators, preparation, and financial arrangements, including insurance require minimum scales to be viable. At the most basic level, and risk management (IFC 2019a). Other parts of the missing the capacity of countries to raise long-term funding in local financial infrastructure can also be provided by the MDBs in currencies is correlated with the size of the economy.55 Prima their roles as financial intermediaries. However, increased facie evidence of the importance of scale economies in lending resilience could be realized from the existence of third comes from the concentration of international bank flows parties who provide markets for resale of the securities or for in infrastructure finance into a limited number of emerging insurance services. market economies (EMEs). Moreover, the banks that engage in such lending are highly concentrated as well. 4.3 Third Level: Financing with The existence of markets or arrangements that enable different institutions to specialize in taking on different portions of the Concessional Terms financing responsibility over the life cycle of complex projects Even with all the infrastructure in place, there are still socially is an important source of cost reduction. Technically qualified valuable investments that do not generate sufficient capturable contractors and sponsors are in limited supply. Their financial revenues to be a profitable project for a private investor, given capacity is also limited. As such, they are best used by recycling their capital costs and risk and liquidity characteristics. In this it into new investments once the job is done. Hence, there is a case, a public subsidy may be appropriate. In principle, a need for long-term investors. However, some global portfolio subsidy can occur directly, for example, through a government investors are likely only be interested in investments in liquid or philanthropic grant to an investment project.57 Alternatively, markets with sizeable volumes of standardized instruments. it can occur through concessional terms at below market Therefore, few developing economies will be able to satisfy interest rates or on favorable terms for maturity, while also such investors on their own. including security or guarantees. Blended finance mixes government or donor provided concessional finance with In countries with a fully developed financial structure, private sector commercial finance (IFC 2021a). If a portion specialization is accomplished through financial markets 54. For example, Eichengreen and others (2002). Arguing against this viewpoint are Reinhart and others (2003). 55. See for example, Hausmann and Panizza (2003); for a contrasting view, see Guscina and Jeanne (2006). Other factors include the development level and macroeco- nomic policies, including monetary stability. 56. See Filho and others (2015) as cited in Garcia and Rudolph (2017, p. 26). 57. See the discussion of “Viability Gap Funds” (Garcia-Kilroy and others, 2023, p. 78). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 30 of the cost and risk is taken on by a government or a non- funding can be self-sustaining. If the development of the profit entity, then a profit-seeking firm is willing to take on the market means that private institutions will eventually be able remnant. If there are limits to the public funding capacity, then to replace the MDB’s operations, then ambitious development the joint arrangement is of both public and private benefit. goals will be reachable; otherwise, they will always be limited by the capacities of the MDBs. Furthermore, there is a When governments provide subsidies, best practice concern that subsidies may be wasted. For instance, they recommends that they be explicit in the interest of transparency may support commercial investments that could stand on their and effective targeting (Kingdom and others 2012), rather own. The remedy for this is the use of competitive tendering than implicit through concessionary terms, the costs of which wherever possible, with concessional terms minimized by are sometimes difficult to decipher. Indeed, this is a standard comparing bids from financial institutions.62 that few governments are able to achieve in practice. Indirect subsidies may cause inefficiencies. When government development entities have passed along subsidized interest 4.4 Fourth Level: Full Public Funding rates to borrowers, they have sometimes crowded private investment out of the field.58 The next level of the hierarchy is projects that should not be carried out through private finance, mainly because they The MDBs and DFIs offer loan terms that for-profit financial yield insufficient capturable revenues vis-a-vis the associated institutions would not offer on their own. Arrangements in project risks. In principle, the MDBs should provide funding which such offers are combined with commercial lending are only after exhausting the other possibilities. One difficulty with among the most visible techniques used in attracting private this approach, however, is the mismatch in practice between investment.59 Generally, the participation includes some form the incentives within the MDBs and the goal of crowding in of risk reduction. For example, the government or the MDB private finance. At the ground level in some DFIs, too much takes on the risky tranche of the loan or offers an insurance attention may still be placed on measuring progress by the arrangement providing for partial repayment in certain size of the DFI’s commitments rather than the private financing contingencies. In this regard, apart from direct lending, the mobilized in the process. World Bank Group also offers a variety of guarantee programs through MIGA (World Bank Group 2016).60 It is particularly difficult to define the extent to which credit 4.5 Fifth Level: Ineffective enhancements or other insurance arrangements are being Investments provided on concessionary terms.61 When an MDB is participating in an intervention as a guarantor, its role is At the bottom of the hierarchy are projects which should not ambiguous. Is it simply acting in the role of an investment be carried out at all. Even here though, there is a role for bank, providing the expertise that a private intermediary would the MDBs. Their goal should be to ensure that projects are offer once the market has matured, or is it acting as the provider evaluated correctly by the governments contemplating them, of a subsidy in order to multiply the limited funds it has for including by not disguising the costs through inappropriate development projects? While the program can be worthwhile use of off-balance sheet guarantees and subsidies, and by either way, the answer to this question is important because not allowing their presence to discourage private funding of it predicts the extent to which growth in the use of institutional the other investments. In the long run, the presence of private 58. BNDES in Brazil is an often-cited example, although since 2015 it has adjusted its policies in an attempt to encourage private sector co-financing (Frischtak and others 2017; World Bank Group undated-a). While the use of risk mitigation is still a relatively small part of MDB activity, over time, the danger may also arise that the risk mitigation instruments themselves will crowd-out risk-mitigating products provided by insurers. The GIF downstream financing window, for example, attempts to focus on “bottleneck” risks unserved by alternative instruments (SwissRe 2020, p. 18). 59. For instance, DAC (2020) provides detailed methodologies for estimating funds mobilized through the provision of guarantees. 60. As of 2019, 48 guarantee transactions utilized US$7.4 billion in International Bank for Reconstruction and Development (IBRD)/International Development Association (IDA) commitments. Additionally, the World Bank approved 15 guarantee transactions utilizing US$1.5 billion in IBRD/IDA commitments that are in final negotiations with private financiers. (https://www.worldbank.org/en/programs/guarantees-program). 61. Recognizing these difficulties, the IFC and other agencies have developed methodologies to attempt to estimate the subsidies included in blended concessional finance, and to report these publicly (DFI 2019). 62. These concerns are recognized as principles guiding the use of blended finance (IFC 2021a). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 31 institutional investors aids in this task as well, specifically, by serving as a brake on the temptation to undertake undesirable projects, which otherwise might be bundled into general investment funding by a government. Given the inherent political temptations, it is important to have in place mechanisms which help to reduce the incentives for governments to fund projects with low social returns. For example, the use of user fee-based arrangements offers the opportunity to filter out politically motivated infrastructure projects. For this to work, it is necessary for the financier of the project to bear the risk of accurate appraisal of the project’s revenue generating capacity. In the moral hazard literature, the basic concern in contract design is balancing insurance needs with incentives for efficient behavior (Laffont and Martimort 2002). For example, if demand risk is transferred to the government because of the inability to attract concessionaires, then the financiers will no longer properly carry out their filtering role. For the MDBs and DFIs, serving as a brake on undesirable investments can be a difficult role. Domestic DFIs without governance structures guaranteeing independence are particularly vulnerable. However, the MDBs can also be placed in a vulnerable position if investment opportunities are limited — and if their incentives are aligned too closely with the volume of transactions undertaken. A government may demand support for an undesirable project as the price to pay for access to participation in more desirable projects. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 32 5. >>> CHAPTER 5: TYPOLOGY OF MDB AND DFI ACTIVITIES In the pursuit of participation by institutional investors, the MDBs have a variety of roles.63 Although many of the duties of a MDB are identical to those regularly undertaken by large, for-profit financial intermediaries, some roles are distinctive. Given their mandates, the MDBs engage in activities that for-profit enterprises would not be willing to undertake. While commercial financial intermediaries serve as advisors both to borrowers and lenders, the MDBs work with governments at a broader level than typically taken on by for-profit institutions. The MDBs also operate on a variety of scales. For example, for some large projects, the participation of the MDBs reaches down to the level of the individual investment. The roles discussed below apply to those transactions. The most significant involvement of the MDBs, however, is likely to be at the approach-based level, that is, developing and participating in an investment program. For example, this could be through a Public Infrastructure Fund (PIF) or a PPP framework. At the broadest level, their involvement entails advice, research, and standard setting—such as guidance on the development of markets, legal structure, regulation, and technical capacity. 5.1 Actions Common to MDBs and For-Profit Financial Intermediaries As an example, the role played by an MDB acting as a general partner in a syndicated loan is considered. When employing other institutional arrangements, the MDB can take on analogous functional roles. Syndicated lending is one of the most basic forms of mobilization used by the MDBs. In some emerging markets, syndicated lending for infrastructure projects occurs frequently — without requiring any input from MDBs. It is done by syndicates led by international banks or larger local banks. In countries with less developed infrastructure, MDBs play an important role in syndicated lending. The IFC has used syndicated lending for more than sixty years (IFC 2019c), enabling commercial lenders, generally commercial banks, to provide direct 63. Instead of starting from the roles of the MDBs, the typology of starts from the form of finance provided: equity and debt (subdivided into deal-by-deal or plat- form-based), guarantees (whether project- or policy-based), and bonds, plus “advisory services”—mostly assistance in developing infrastructure projects for PPPs (World Bank Group 2020a). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 33 financing alongside the IFC’s lending. In a syndicated loan, a pipeline, or the development of such a pipeline with appropriate MDB generally can take on many roles (see below) typically characteristics. The selection of projects (including due engaged in by asset management or private equity institutions. diligence and risk assessment) requires expertise. Talent selection in one arena will not generally spill over into talent selection in other arenas.65 Therefore, it is economically 5 .1 .1 I N I T I AT I O N rational for investors to delegate the selection of investments to entities with the expertise for those projects. The MDBs are Someone has to start the process. Financing and investment experts in low-income, fragile and frontier markets. As such, will not flourish without a party willing to take a lead role.64 they specialize in borrowers in countries with high credit and Attracting potential investment partners—that is, generating financial risk. These are overrepresented in syndicates to a list of clients interested in providing finance—is, in itself, a borrowers in low- and lower middle-income countries relative long-term investment. Developing and exploiting a successful to those in emerging markets (Gurara 2020). While MDB track record to maintain the interest of these clients and attract participation in syndicates is widespread across industries, additional clients is also part of the job. For example, the costs they have a greater than expected presence in agriculture, of doing so will be higher when expanding into a new sector again possibly indicative of specialized expertise. of investors. However, it is important to understand that private intermediaries The tasks of initiation occur both at the transaction and the are also in the business of developing expertise. Indeed, they approach levels. The Philippine Investment Alliance for may have superior resources to do so once a market becomes Infrastructure (PINAI) provides an example of the importance sufficiently large.66 of the various roles taken on by an initiator. The PINAI is a closed-end fund for infrastructure assets in the Philippines. Thus, it would be expected that the MDBs’ specialist The government provided the concept, and the platform was expertise would be most valuable for the smallest and least designed, mobilized and structured by the Asian Development developed markets, as well as in markets where country risk Bank (ADB). The ADB was also instrumental in bringing in the is extremely important.67 major investor. The private firm Macquarie Infrastructure and Real Estate acts as the fund manager and general partner (CEPA 2020; OECD 2014). 5.1.3 STRUCTURING PRODUCTS General partner structures are designed to internalize some of The options for the structuring of products are limitless. the rewards of initiation. In the sample examined by Gurara How should payments be related to performance? Are the (2020), the MDBs were participants in only 10 percent of the arrangements more debt or equity heavy? What preferences loan deals. However, they were the lead arrangers for the are given to the various participants relative to one another, majority of syndicates in which they participated. and relative to the intermediary? In particular, what insurance or guarantees are allotted to the participants? What are the possibilities for early withdrawal of funds, either by redemption 5.1.2 PROJECT COLLECTION AND with the intermediary or by resale? What recourse is allowed in SELECTION terms of collateral, cross-guarantees, or through the resources of the intermediary itself? While it is always easier to attract borrowers than lenders, the challenge is to attract viable borrowers who can potentially Structuring is first of all a matter of allocation of cash flows be matched with the lending clients. Thus, the job requires and risks. Irwin (2007, p. 56) notes the fundamental principles selection of suitable projects from an already available of risk allocation. Specifically, value is maximized when risks 64. CEPA (2020) provides illustrative examples of the importance of a lead in global investment platforms. An arrangement in which too many participants share top responsibilities results in free riding. Monk and others (2017) proposes techniques to build social networks to deal with free riding (the so-called “stag hunt”). 65. Specialization and expertise in selection have been extensively studied in the case of venture capital. For the importance of specialization to returns see Gompers and others (2009). 66. Hochberg and Westerfield (2011) model the importance of specialization in investing, concluding that, while experience is likely to lead to greater breadth of investment, riskiness and competition are forces that encourage a more specialized focus on smaller numbers of projects. Increases in availability of opportunity bring in larger agents with more generalized skills. 67. Gurara (2020, p. 8) notes that one important source of the MDBs’ superior information is their access to country-level data and their collective agreements with one another. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 34 are allocated to the party that can most influence the risk 5.1.4 INVESTING AND FINANCIAL (moral hazard) is best informed about the project dependence COMMITMENT on risk (adverse selection), or is best able to bear the risk.68 For example, exchange rate risk is one of the most Because of their characteristics, the MDBs have low costs for important components of project risk. Optimal allocation of capital at the scale at which they operate. That makes them exchange rate risk must balance the comparative vulnerability a natural source for investment. Moreover, they are better and capacities of foreign lenders, domestic governments, able than most private financial institutions to manage long- borrowers, DFIs and MDBs,69 taking into consideration the term lending. However, this low capital charge is not scalable; extent to which governments have control of policies affecting rather, it depends on the maintenance of confidence and exchange rates.70 support from sovereign institutions in developed economies, either of which could be lost if the MDBs were to grow These principles become even more difficult to apply in precipitately. Private capital mobilization is an attempt to complex, long-term arrangements where information about extend the MDB’s financing capacity. Thus, investing by the risks sometimes resides with one party, whereas the control over MDB ideally should kept at the minimum necessary to provide risks resides with another. For example, PPP arrangements comfort to the investment partners in the project. The stake can be structured so as to allocate risks at various times to the cannot be zero. Some degree of financial commitment is a government, the lender, or the sponsor, with varying effects signal to co-investors that the MDB has indeed vetted the on their incentives to monitor, operate efficiently, and screen investment and stands behind its guarantee of quality. carefully. Some long-term investors, such as pension funds, will find the risks at the construction stage to be too expensive Financial commitment can take many forms. The MDB to tolerate. As such, they may want to delay providing capital could provide direct insurance to other participants (“private until later phases. However, since there is value in recruiting direct mobilization”, see World Bank Group 2020a, p. 9). institutions with varying risk tolerances, the knowledge that For example, when attempting to conserve MDB capital, one class of investor is interested in joining makes it more numerous observers have advocated for the use of credit attractive for other classes to participate as well.71 enhancement products (SwissRe, 2020, pp. 17-18). In the IFC’s Managed Co-lending Portfolio Platform (MCPP), having Structuring is important for handling the other needs of potential taken responsibility for the other portions of the investment investors apart from risk allocation. For institutional investors, activity, the IFC brings in partner investors in a portfolio, the following considerations are relevant: demand for long- while also maintaining a share of the investment on its own or short-term instruments; the need for credit enhancements account.72 Taking a subordinate loan position not only adjusts to satisfy particular institutional investors’ regulatory the loan products to the risk needs of the other lenders, it requirements; and preferences for funded or unfunded also signals the confidence of the MDB in the project, thereby participation. For example, the IFC Credit Mobilization encouraging indirect mobilization. (Hagen 2009). Finally, the Solution enables insurance companies to participate in loans stake need not be a funded stake. For example, guarantees on an unfunded risk-sharing basis (IFC 2018), arguing that can provide confidence while also generating large crowding- unfunded structures are a natural fit for insurance companies in multipliers.73 when working with the MDBs (IFC 2019b, p. 32). 68. Vecchi and others (2017) also provide a classification for allocating infrastructure project risk. 69. The inclusion of insurance companies in the mix as holders of the exchange rate risk is a possibility which is just beginning to be tapped (see IFC 2019b, p. 34). 70. Political risk is another important example. While governments are most able to affect political risk, they may not always be in a position to provide credible guaran- tees against it. With respect to loan guarantees, the IBRD and the IDA generally cover risks within the control of the government and public entities (World Bank Group 2016). This allocation is natural partly because of MDB expertise in evaluating political risk, and partly because of their power to forestall it, as discussed below. 71. Garcia and Rudolph (2017, p. 78) provide an example of this sort of complementarity in infrastructure investment in Chile. 72. The MCPP is examined in Garcia-Kilroy and others (2023, p. 56). 73. For example, as of 2019, the mobilization of US$30.2 billion in commercial financing, plus US$20 billion of public financing, is supported by guarantees using US$7.4 billion in IBRD/IDA commitments. Guarantees in final negotiations would utilize US$1.5 billion to mobilize an expected total of US$5.4 billion in commercial financing (https://www.worldbank.org/en/programs/guarantees-program#6). It is argued that structured financial products and credit enhancement, including partial guarantees, have a larger multiplier effect than direct lending. Debt financing with senior debt is especially expensive in terms of the use of credit capacity (World Bank Group 2020b). Still, guarantees and enhancements are not free. They represent contingent liabilities against which capital should be allocated. In this regard, the MDBs are subject to the same temptations as other financial institutions regarding the under-provision for them in their accounting systems. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 35 5.1.5 MONITORING can be classified into three categories: subsidizer, advisor, and enforcer (or more, diplomatically, guarantor of reputation). The work is not finished when the money is handed over to the borrower. Someone must monitor the progress of the project and adherence to the terms, including whether 5.2.1 SUBSIDIZER conditions have been met for any additional payouts; whether changes in activity (including shutdown) are warranted; and The MDBs take on financing tasks that the private sector whether renegotiation is to be attempted. The delegation would be unable to undertake by itself. Partly this is because of monitoring responsibility saves the duplication of costs, of superior expertise. However, it is also partly because which is particularly important when monitoring costs would of differences in mandates. The fundamental mandate of exceed the capacity of a single, risk-averse lender desirous of the MDBs is the promotion of socioeconomic development, diversification. (Diamond 1984, 1991). whereas the fundamental mandate of private financial institutions is profit maximization. Thus, lending risks and For example, defined contribution pension funds will prefer the returns that would be acceptable for a MDB need not be terms role of minority investor in most development finance contexts. that would be necessarily acceptable on the open market. As such, they will usually be unwilling to take on monitoring responsibilities.74 Therefore, the structure will require that Sometimes the subsidies are explicit. For example, the some other entity shoulder the burden. Among the possibilities Caribbean Investment Facility (CIF) uses funds from the are the inclusion of domestic commercial banks with equity European Development Fund in alliance with a variety of stakes, or general partners in infrastructure funds.75 MDBs, largely to provide grants for development projects intended to leverage other sources of financing (CEPA 2020). This analysis also points to a potentially important role for There is a debate as to whether ESG investing is simply a insurance companies in structured arrangements. If an technique for improving long-term returns (by incorporating individual insurance company agrees to cover the entirety a focus on previously underappreciated factors, such as of a particular risk, the arrangement induces the insurance environmental impact, the relationship with communities, company to engage in risk reduction. In particular, the company and management culture)77 or a duty of investors to take into has the incentive to monitor the conduct of the project and account negative social externalities along with the financial negotiate with other parties (sponsors, governments), should return (see discussion in Aubry and others 2020). In any conditions warrant. In other words, for dimensions for which event, several soft financing windows provide subsidies for an insurance company is likely to have expertise, it makes green investing, thereby encouraging projects that could not sense to recruit it as the delegated monitor.76 meet market rates of return.78 There seems to be some uncertainty about the appropriateness of the MDBs providing indirect subsidies. It is strongly 5.2 Actions Unique to the MDBs recommended that governments make their subsidies explicit. It is also recommended that domestic DFIs not provide Because of their mandates, the MDBs engage in a variety of subsidies, and instead have any subsidies come directly from activities that for-profit enterprises will not undertake. These the government in a quest for transparency. Nonetheless, it is 74. Pension funds engage extensively in shareholder activism for shares in organized markets, sometimes in an attempt to improve firm governance and sometimes for explicit political or social goals (Wang and Mao 2015). In these contexts, the costs of intervention are greatly reduced by the presence of specialist services in highly developed financial markets. These services provide institutions with advice on proxy voting. For example, the Institutional Shareholder Services (ISS) group provides ratings and recommendations concerning governance and ESG, as well as proxy recommendations to its customers (see https://www.issgovernance.com/ policy-gateway/voting-policies/). However, there is an ongoing debate as to whether corporate governance ratings provide useful information regarding firm value. For example, compare Calomiris and Mason (2010) and Guest and Nerino (2020). 75. The corporate finance literature devotes extensive attention to the link between effective monitoring and the financing structure or size of holding. In the simplest circumstances, making a delegated monitor’s investment large and illiquid will increase the willingness to intervene. However, in general, the relationship is complex. For an introduction to this line of research see Maug (1998) and Kahn and Winton (1998). Also, see the more recent work of Beck and others (2018). 76. This was a role taken on by monoline insurance companies before the financial crisis. Their insurance products included considerable credit enhancement, which became infeasible as the companies’ own credit ratings were downgraded relative to the bonds they were covering (Stevens and Bond 2013, p. 88). While the expe- rience shows the limitations of the strategy, a more modest approach remains applicable to risk reallocation in development finance. 77. For example, according to BlackRock’s website concerning ESG integration: “ESG data … captures components important for valuations that are not traditionally reported … Incorporating these considerations into the investment research, portfolio construction, portfolio review and stewardship processes can help enhance long-term risk adjusted returns … Our portfolio managers are able to bring useful ESG information into their investment processes, discounting or emphasizing this information as they would any other financial input.” https://www.blackrock.com/institutions/en-us/solutions/sustainable-investing/esg-integration 78. Climate change funding initiatives include the Green Climate Fund, the Global Environment Facility, the Clean Technology Fund, and the Strategic Climate Fund. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 36 accepted that DFIs and MDBs can afford to accept a lower rate of return on projects of a given risk than would be acceptable Knowledge transfer can take place casually through co- to private investors. It would appear then that the provision of investing or explicitly through the promotion of programs insurance and guarantees at non-market rates is acceptable. and training of participants. To encourage the transfer of The justification given is the need to complete missing or knowledge, the MDBs will want to ensure that incentives underdeveloped financial markets. In other words, if those within the MDB are structured correctly. This helps to reward markets were in place, the risk-adjusted costs would become innovation, which in turn leads to reduced information costs low enough to conduct the activity on a commercial basis. to the market, for example, credit information or pipeline information at the national level. However, there is one important way in which MDBs provide a more subtle indirect subsidy, that is, in the generation of information. As noted, the MDBs have a natural comparative 5.2.2 GOVERNMENT ADVISER advantage for some forms of information-gathering. However, even if they did not, the difference in the objectives of the For both private and public intermediaries, providing advice MDBs and those of the private financial institutions will lead to borrowers and lenders is an important part of the job. to the MDBs sometimes taking on the information collection However, with respect to advice to governments concerning role. Information collection is a classic public good. A free- policy and legislation, the role of the MDB is broader than that rider problem arises when one investor collects information typically taken on by private institutions. on a borrower’s creditworthiness, but other investors are able to infer that information without paying for it.79 Much of the Since the problems of short-term thinking and hold-up structure of syndication is designed to ensure that the lead are central to the limitations of government finance of arranger is adequately reimbursed for information gathered. development, the MDBs’ advice often focuses on assistance However, a partial alternative occurs when an agency with a in the development of structures in which governments can broader mandate accepts the role of supplying the public good. credibly assume policy risk through the development of This becomes even more important when the information independent arbitration and legal certainty (Irwin 2007, p. 99). is broadly applicable to a large collection of investment In nascent markets, the relevant forms of advice cited by the opportunities, such as information about macroeconomic and World Bank Group include the development of government political risk within a country (as in the model of Hagen 2009). bond markets and improvement of corporate governance and financial reporting; developing credit infrastructure; reforming In the long run, the public good aspect of information provision pensions and stimulating savings (World Bank 2020d). MDB is even more important. Classic business strategy mandates expertise across economies often results in their playing a role that an investor look for opportunities providing a “sustainable in the setting of standards for institutional procedures or for competitive advantage.” Investment in information is the classification of financial instruments. particularly vulnerable in this respect. Once the technique has been discovered, it becomes easier for imitators to copy As a country’s financial structure develops, the advice focuses it, thereby cutting into incumbent returns. For this reason, for- on more detailed and specific concerns in various categories profit institutions will always be wary of investing in the know- of investment. This new forms of advice are intended to how to develop markets in which they can be supplanted.80 increase the range of issuers of financial instruments, as well However, the MDBs will be enthusiastic about creating new as the range of purchasers of such instruments. With respect market structures, transferring the knowledge to the for-profit to PPP investment, the MDBs provide advice on project participants, and then exiting from the arrangements once preparation facilities and policies. They also provide advice they are able to run independently.81 on developing a sound enabling environment for identifying, 79. The problem can be clearly seen in the related policy question of who should pay for the services of credit-rating agencies. Kashyup and Kovrijnikh (2015) model the issue showing the variety of incentive difficulties arising from various compensation arrangements, including the possibility of a collapse of the system due to free-riding under an investor-pays system (when non-paying investors cannot be excluded from the information). 80. Patents are the classic form of protection used to encourage innovators to bear the upfront costs of their innovations. Historically, financial innovations were not patented, although this has changed in recent years. For the effects of patent protection on financial innovation, see Lerner and others 2020). They also point to the importance of involvement of non-profit institutions in maintaining the flow of financial innovations. 81. For instance, the IFC points to the imitation of its Green Cornerstone Bond Fund (GCBF) structure by private sector partners as an indication of its success and scalability (World Bank Group 2020). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 37 selecting, preparing, budgeting, procuring, monitoring, and When local DFIs are organized with sufficient independence auditing projects in a timely fashion.82 The most ambitious and expertise, they can play a similar trusted role. With and long-term advice and assistance concerns the creation respect to PIFs, the World Bank Group (2020b, p. 47) argues and development of financial markets themselves, such as that based on case studies, DFI participation improves markets for listed bonds for infrastructure projects. governance. This is not just because of technical expertise, but also because the due diligence of the DFI provides The development of ESG and climate-related opportunities credibility and international recognition. Furthermore, board provides a recent and significant example of the advisory membership, typically granted when the DFI is an equity role taken by the MDBs. There is currently enormous holder in the PIF, provides further credibility. interest in ESG investing,83 as well as in the development of principles for evaluating investments on the basis of The confidence other institutions hold in the independence ESG.84 The increased appetite for sustainable investing by of the advice of the MDBs or DFIs is potentially undermined both private and public investors provides an opportunity by conflicting incentives. For example, this can occur when for developing nations, if they can build the capacity to a DFI has a role both in the design and the evaluation of an offer those options. Thus, in addition to the other aspects investment instrument. In such cases, it may be necessary of capacity building in developing economies, the MDBs are to provide greater credit guarantees to inspire confidence well-positioned to advise on these new challenges, including in the particular projects, as well as in the arrangement. (i) adapting projects to sustainability criteria; (ii) documenting Such a conflict of interest potentially imposes a limit on the the conformance of proposals with ESG standards; (iii) effectiveness of the whole-life-cycle approach. developing legal structures to enforce environmental and governance requirements; and (iv) building the capacity to With respect to political risk and sovereign counterparty risk, search for and obtain the financing under available programs the participation of the MDBs inspires confidence in private for ESG and climate-related concessionary financing. At a parties, not just because of the MDB’s trustworthiness. The more general level, the MDBs are partners in establishing MDBs have a superior position as lender and guarantor in international sustainability guidelines, such as the “Aligned part because of their power. Hainz and Kleimeier (2012) Set of Sustainability Indicators” (Inter-American Development argue that the MDBs provide a “political umbrella” through Bank 2020), as well as in formulating best-practices. their ability to influence government policy and deter actions that would damage the outcome of investments. Thus, MDB participation in loan syndicates helps mitigate political 5 . 2 . 3 G U A R A N T O R O F R E P U TAT I O N risk by providing, among other things, a signal of the MDB’s willingness to take on these activities. Gurara (2020) provides Because of the MDB’s reputation and non-profit orientation, confirming evidence in the difference of the effects regarding it has a trusted role in interactions with governments and MDB participation, particularly on the costs of funding for local and international financial institutions. Its participation public sector versus private sector borrowers. in interventions is a source of confidence for all parties in both the social and financial value of the arrangements. Gurara (2020) also emphasizes the potential importance of The MDB’s expertise and experience reinforce this the MDBs in extending their de facto preferred creditor status confidence. When involved in a particular project, the to other lenders in their syndicates, when the syndicate is MDB’s participation is an indication of its soundness. When structured as A/B loans, rather than as parallel lending. The involved in the design of private infrastructure funds or PPP ultimate source of their power is likely to be conditionality. structures, the MDB is also in a strong position to vouch for although other authors (Hagen 2009; Rodrick 1995) also their transparency and autonomy. emphasize the limitations to the MDBs’ enforcement powers. 82. For example, Garcia and Rudolph (2017) note the detailed advice concerning the practical steps needed for successful PPP initiatives, including legal and policy frameworks, necessary staffing and structures, and processes. 83. In Europe, sustainable fund assets account for roughly 12 percent of total investment fund assets. (Morningstar 2021). Sustainable fund flows constituted nearly a fourth of overall net flows into stock and bond mutual funds in the U.S. in 2020 (Hale 2021). 84. A large number of ratings agencies, both general and specialized, provide ESG ratings. For a comparison see Huber and Comstock (2017). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 38 6. >>> CHAPTER 6: CONCLUSION In order to achieve the United Nations Sustainable Development Goals (SDGs), it is essential to increase funding from institutional investors. The theoretical and empirical literature concerning MDB mobilization of private capital offers little guidance regarding which techniques can be most effective. This paper uses general principles and sets out basic hypotheses. Specific analysis for different sectors (as done for housing and infrastructure in separate studies85) may help reflect on the circumstances in which these hypotheses become significant. Meanwhile, the hypotheses lead both to tactical considerations and to implications for the functioning of the MDBs. 6.1 The Context Although institutional investors are a natural target in the mobilization of funding by the MDBs, institutional investors cannot be treated as a homogeneous class. There is a great variation that can be expected from different institutional investors regarding the extent of investment and degree of participation. A fundamental distinction among institutional investors is the extent to which they require intermediation services, and, in particular, which services are needed. At one extreme are the institutional investors willing to devote the resources to evaluating and monitoring individual securities or projects in an EMDE. At the other extreme are the institutional investors only willing to invest indirectly by purchasing the equity or debt of international financial institutions that in turn take on the responsibilities. In between, there are a variety of intermediate levels of participation, including: investing in particular portfolios arranged by intermediaries on a bespoke basis (separately managed accounts); or in funds, listed or unlisted, arranged by intermediaries; or through shared-cost platforms, which provide advice on particular instruments, as well as opportunities for co-investment in those instruments.86 The next question is which type of institution is best able to provide these services—a MDB or a DFI, an existing for-profit financial intermediary, or a specially-designed entity. Strategies need to be adapted to the particular investors, as well as to the investment sector and the level of development of the country and its financial sector. 85. Walley and Vidal (2023) and Garcia-Kilroy and others (2023). 86. See CEPA (2020) for examples. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 39 Successful transactions-based activities for bringing in to supporting a wide range of enabling reforms. In many institutional investors require the MDBs to refocus on their circumstances, these reforms would be at least as relevant comparative advantages relative to institutional investors. to transaction-based engagements by the MDBs. Country These differ from their comparative advantages relative authorities — including Ministries of Finance, Central to the banks. When designing and recommending strategies Banks, capital markets, pension and insurance regulators — for crowding-in institutional investors, the MDBs must consider commonly count on MDBs to provide expertise to enhance the their own strengths and weaknesses. Overall, the MDBs have legal and regulatory framework, improve market infrastructure, a set of comparative advantages. They have expertise in some and deepen financial markets through an extensive agenda of investment sectors. They have experience in navigating among reforms to facilitate investments. governments and for-profit institutions. Also, they generally have the trust of those various parties. Their status makes their The current interest in ESG investing provides an important cost of capital low at current levels of funding, thereby making example of opportunities for the use of the MDBs’ powers it easier for them to collect on sovereign debts than it would be to crowd in institutional investment. ESG investing has for most private sector lenders. become mainstream. For some classes of institutional investors, it is a priority. Some investors are willing to accept Relative to insurance companies and pension funds, the MDBs lower risk-adjusted returns from investments that provide are likely to have superior skills in the initiation of transactions, positive environmental or social externalities, and many more as well as in the evaluation of the governance structures of investors are screening potential investments utilizing ESG the arrangements being established. Relative to institutions metrics. Institutions with an interest in ESG investing, but who are new to the sector, or to those not intending to become without background or experience in development investing, major investors, the MDBs are likely to be better evaluators are a natural market for MDB engagement. In the past, the of credit quality of individual projects and investments. This fact that an investment was going into a developing economy contrasts with their skills relative to those banking institutions might in itself have been regarded as convincing evidence for that have been in the sector for many years. Whereas banks its social benefit. Now, that argument has to be made much are likely to have shorter time horizons than the MDBs, the more carefully, given heightened suspicions about possible new institutions are likely to have longer time horizons. With adverse environmental or social impacts. respect to some dimensions of risk management, insurers are likely to have greater expertise. With respect to others, the The standards that are applied are varied, complex, and advantage will lie with the MDBs. constantly changing. However, if investments can be shown to meet the requirements, the financing alternatives available Transactions that take advantage of these differences in skills would expand dramatically, and significant concessional include credit-enhanced infrastructure bonds in which the terms would become available. The MDBs have the expertise dimensions of risk are allocated to an individual insurance to navigate these requirements, thereby bringing together company, which can serve as monitor and renegotiator. institutional lenders and developing economy borrowers. Other possibilities proposed include developing insurance products for exchange rate risk, thereby using the expertise of The MDBs are attempting to tap into this potential. Thus, it insurance companies to deal with one of the main bottlenecks is a priority to carefully determine the extent to which MDB in encouraging international institutional investing.87 involvement in improving ESG documentation and preparation in developing economies is effective in improving these Heterogeneity of institutional investors and diverse levels countries access to new sources of institutional investment. of economic and financial sector development across EMDEs indicate that the MDBs’ advisory role will be critical 87. The usefulness of exchange rate guarantees provided by international agencies is controversial. Irwin (2007) and Engel and others (2020) provide arguments against them. Thus, the development of the capacity of for-profit insurance companies may be a solution. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 40 6.2 Hypotheses products and guarantees within a country are the starting point. However, for smaller countries, it is also important that 6.2.1 SCALABILITY reforms be undertaken vis-à-vis regulatory and legislative arrangements in accordance with international standards. The quest to crowd-in institutional investors, implies an increased focus on platforms and large-scale A recurring pattern in the implementation of development intermediaries rather than direct participation. The MDBs finance solutions is the establishment of a specialized, jointly have limited financing capacity compared to the private sector. sponsored institution to carry out a standardized procedure The same logic that induces the MDBs to attract institutional for providing a financial product.89 Generally, the new entity is investors into development finance should induce them to established to provide a product that has thus far been missing attract international asset managers to, in turn, attract larger from the financial structure of the country, such as mortgage numbers of institutional investors. Intermediation is the refinance or insurance vehicles. The products provided can be solution that arises in established financial markets when attractive for generating interest from international institutional individual investors are too small to carry out monitoring investors. Sponsorship from a combination of government, functions on their own, or when small individual projects need private and MDB or DFI sources plus ex-ante capitalization, to be consolidated to repackage and reallocate risks. When gives the institution a measure of independence. Housing it in such intermediaries do enter new markets, they are capable a separate structure offers the potential for the entity to gain its of carrying out the financial engineering and the marketing to own credit ratings, eventually issuing debt both into local and clienteles necessary to make the investments attractive. international financial markets. A successful pattern offers the potential for replication in other countries, while also allowing Enlisting asset managers is not a panacea.88 Since the for adjustments to local conditions. objectives of these institutions are not the same as the objectives of the MDBs, careful arrangements must be made to reconcile differences. Nonetheless, the ability of large-scale 6 . 2 . 3 I N I T I AT I O N intermediaries to access clients and their expertise in devising structures tailored for those clients complements the skills of The power of MDB initiation of approach-based activities the MDBs. The complementarity enables rapid mobilization Is associated in part with MDB willingness to see the at scale. Platforms are a second route to achieving scale. programs move to the private sector once the concepts The MBDs are natural sponsors of platforms, and they can have been proved. If a for-profit financial institution initiates be attractive alternatives for institutional investors who would a new approach to investment, it needs to recoup the costs of prefer not to work indirectly through a large-scale intermediary. development. The costs include a risk charge for the likelihood that the approach does not succeed. The compensation for these costs must come from the revenues that the program 6 . 2 . 2 S TA N D A R D I Z AT I O N generates over time. However, new methods of finance are not patentable. If the program is easily duplicable, then its success Standardization is the primary tool for achieving will generate no extra profits for the innovator because of entry scalability. Standardization reduces barriers to participation by imitators. Thus, this process poses a serious deterrent to at all levels of the investment process. Eliminating the costs innovation by for-profit institutions. of duplicative investments in learning anew the procedures for participation in an investment project, or terms and conditions Relative to for-profit institutions, a distinctive feature of the involved, makes it possible for a small institutional investor to MDBs is their ability to walk away from operations once they enter the new market, or for a large institutional investor to find become successful. When measuring the sustainability and the exercise worthwhile. Standardizing pipeline processes, scalability of a technique, the MDB is interested not in its profitability for itself, but rather in the viability of the program 88. For a critique of the effectiveness of intermediaries as investors of the funds of institutional investors, see Monk and others (2017, chapter 1). For example, Industry Funds Management, an investor-led co-investment platform, argues that it provides the benefits of aggregation at a lower cost than achievable through private fund managers (CEPA 2020). 89. The case of GuarantCo is discussed in (Stevens and Bond 2013) and reviewed along with additional examples in Walley and Vidal (2023) and Garcia-Kilroy and others (2023). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 41 without its presence. For a MDB, the fact that a program has reputation for independent advice and information. When it been imitated by for-profit institutions is a mark of success. becomes responsible for decisions at too many stages (for Similar considerations apply to the creation of new financial example, the establishment of the program structure, the markets. The MDBs’ initial participation in these markets is upstream project choice and evaluation, and/or the acquisition intended to jump-start them, not to provide a continuing source of long-term investors), its reliability may be brought into of profit for the MDB. Thus, the long-term goal of the MDB question — unless incentives are carefully designed. Possible is to see the financial infrastructure in developing economies safeguards include partial retention of risk and separation of grow to the point where the MDB no longer needs to intervene upstream and downstream operations within the MDB. to maintain viable secondary markets and their services (IFC 2018, p. 3; 2021a). 6.3.2 APPROACH-BASED ACTIVITIES VERSUS INDIVIDUAL 6.3 Tactical Issues TRANSACTIONS BASED ACTIVITIES Approach-based activities, as well as demonstration 6 . 3 .1 T H E W H O L E- L I F E- CYC L E projects and reform at the governmental and international APPROACH levels have greater long-term effects than focus on individual transactions-based activities. However, they The whole-life-cycle approach Is valuable for bringing are also much more difficult to measure and require in various classes of Institutional Investors. However, careful adjustment of incentives within the MDBs. When it carries risks for MDB credibility due to conflicts of the goal is scale and sustainability of mobilization of institutional interest. When financing needs are long-term and complex, finance, the impact comes from long-term development of new with risks which vary over the length of the project, different approaches and markets. Individual transactions are valuable institutions will be interested in providing funding for different to the extent that they serve as a demonstration of the potential segments at different times. A whole-life-cycle approach to the for a new approach; almost by definition, they cannot have the investment, in which responsibilities are reallocated among same impact as the new approaches themselves. participants at various stages, will be attractive for investors unwilling to shoulder the entirety of the risk. However, the early Measuring the long-term impact of a new approach is participants in such an arrangement will need assurance that extremely difficult as compared with measuring the impact funding will be available when the later stages are reached. of an individual transaction. Even the best measures of the Such assurance will either require that all parties agree in crowding-in multipliers attributable by particular transactions advance, or it will require that one party take on the risk and are not measures of the sustainability of the approach that responsibility for acquiring further partners as the intermediate a particular transaction represents. As a compromise, it stages are completed.90 may be necessary for the MDBs to continue participating in arrangements to provide both financial and reputational credit The MDBs are in a good position to organize and participate for the contributions made in the initial stages.91 in investment programs using a whole-life-cycle approach. Their project expertise, their experience in working with wide It is even more difficult to measure the effectiveness of broader varieties of public and private agencies, and their capacity for activities, such as advising governments about regulatory long-run risk put them in a superior position for providing the and legal reforms, although their long-term effects may be insurance and liquidity needed to bring the various parties profound. This poses a considerable challenge for the MDBs together. However, the utilization of the whole-life-cycle in attempting to allocate their resources among the various approach must take into consideration the incentive problems. levels of an activity. For this reason, studies attempting to Part of a MDB’s comparative advantage comes from its document the catalytic effects are of fundamental importance. 90. In the infrastructure note, cases are presented investigating the advantages and limitations of the whole-life-cycle approach for developing a pipeline of projects in countries with weak institutions. 91. In effect, this is the strategy of the IFC’s Infraventure project support, in which early-stage support is provided in return for the opportunity for an equity stake at the project close (IFC 2015). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 42 6.4 Implications for the MDB Role institutions would not be able to develop and test. Although such initiatives are essential to unlocking institutional From the hypotheses, some strategic implications can be investments at a larger scale, incentives within the MDB drawn regarding the effectiveness of the MDBs in facilitating have not always been aligned with these priorities. Thus, to institutional investor mobilization: foster risk-taking and long-term innovation, when the MDBs enter with new approaches, the incentives for fostering ● MDB advisory as an essential function: The traditional initiation should be ingrained in the MDB’s activity. advisory role of the MDBs is even more critical in the context of institutional investor mobilization. Bringing in a new category of investor requires a range of enabling reforms to a country’s regulatory environment. The heterogeneity of institutional investors increases the complexity of the problem. With or without the use of MDB enhancements or co-finance, the advisory function will play a central role in both approach-based and transaction-based activities. ● Strengthening central-local product development capabilities: Reaching scalability, standardization, and fostering partnerships for approach-based and/or transaction-based activities requires a strong product development capability by the MDBs. The coordination of activities at the MDB headquarters and the local level is needed to attain the benefits of scale and replicability. The central offices focus on “top-down” activity, reaching overall MFD goals. However, the local developers will need to test and tailor elements to fit specific contexts across countries and strategic sectors. ● Relevance of DFI partnerships: This report has emphasized the variety of complementary roles played by MDBs and other DFIs in support of institutional investor mobilization—from advisory to enhancement and co- investment functions. Some DFIs specialize in one or another of these roles, whereas some others specialize in particular regions. The geographical reach is critical when scalable solutions involve many countries or regions. 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