Blog Post

MDBs Loans: a New Asset Class Collateralized Loan Obligations

Bretton Woods Committee  | Tue, Nov 15, 2022

by Mahesh Kotecha


Multilateral Development Bank balance sheet management with structured financings is still in its infancy but a number of path-breaking deals show the way. Two are by the African Development Bank (AfDB) and one by  International Finance Corporation (IFC) though there have also been some others. These  MDB transactions involve about $13 billion in public and private sector MDB loans. The two from the African Development Bank are both synthetic. They transferred the credit risks of $1 billion in private sector loans in 2018 and $2 billion in sovereign loans in 2022 to investors while retaining the loans fully on the Bank’s balance sheet. Since 2013, IFC has also implemented a transaction that allows it to co-fund $10 billion of its private sector loans on a pari passu basis with commercial lenders. 

None of these transactions involves a sale of the MDB loans – a more typical route followed by commercial banks engaging in what the market calls “collateralized loan obligations” (or CLOs). A key reason is that multilateral development banks such as AfDB and IFC are accorded a preferred creditor status by their borrowers. MDB loans to sovereign governments, for example, are not restructured by market practice when a country defaults to the Paris Club government lenders or to private sector lenders. If an MDB sells its loans, it is feared that their preferred creditor treatment may not carry over to the private lenders. 

Nonetheless, a September 2022 G-20 Expert Group Report on MDBs urges such loan sales. The report states at p. 35 that “There is a logic for shifting a part of MDB portfolios from an originate-to-hold model to an originate-and-distribute model. Such a shift can be accomplished through outright sales, or by transferring risk to the private sector through insurance or synthetic securitization … freeing up capital for new lending.” 
Larry Fink, the founder of Blackrock (which has $10 trillion in assets under management) supports this view. He has proposed that to attract the private sector, the countries in which the projects are located should bear the “first loss” and MDBs should provide additional “second loss” to protect private investors. If implemented, this structure would transform MDBs from making loans themselves to providing guarantees for loans funded by others. 
The imperative for such a significant reform is driven by some dire realities: 
•    First, COVID-19 has cost developing countries some 5% of their GDP in 2020 and pushed over 100 million people into poverty. 
•    Second, the Ukraine war has led to increases in food and energy prices that many countries can ill afford.   
•    Third, the pandemic, the rising global interest rates and a strong dollar aggravate debt service burdens and have pushed some countries into default.   
•    Fourth, even if MDBs implement the proposed G-20 capital adequacy reforms, they can only unlock an estimated $500 billion to $1 trillion in new investments. 
•    But with current MDB disbursements of only $200 billion annually this is not enough as needs are for $2.5 trillion annually until 2030 so as to achieve the Paris Climate Goals and the Sustainable Development Goals.   

These huge gaps can only be filled with private capital which demands a “de-risking” of its  investments. Here is where the AfDB, IFC and other similar MDB deals to manage their balance sheets show the way forward. They not only demonstrate success in attracting private capital but they also quantify on a preliminary basis the credit enhancement required for risk transfers on pools of public and private sector MDB loans to developing countries at 20%-27.25% of the loan pool. So if the current disbursement of MDBs were deployed instead to attract private capital via credit enhancement, developing country investments enabled by MDBs could rise to nearly $1 trillion from $200 billion, still well short of the $2.5 trillion needed. While required credit enhancement for sale of loan pools may decline as markets gain confidence in the record of low MDB loan losses, other sources of credit enhancement may also be required.  

For MDB loan sales and securitization to take off, the MDB loan CLOs need to be easier and faster to launch. This may require more structuring expertise, better disclosures on historical MDB loan loss performance, broader investor interest and more transparent rating agency approaches on the resulting capital relief for MDBs. There some clear imperatives:   

•    MDBs need to admit their capital constrains, embrace a new role as credit enhancers and originate higher volumes of loans they can sell down. 
•    MDBs as credit enhancers can mobilize 4 to 5 times what they can lend on their own.  
•    Faster growth of MDB CLOs will require more structuring and placement expertise at all levels: among bankers, rating agencies, investors and MDBs themselves. 

In the end, attracting international capital to developing countries takes not only risk mitigation where possible but a reduction of project and recipient country risks. This requires good macroeconomic policy making on the part of the sovereign governments, sustained implementation of such policies, a business friendly environment, the rule of law, good governance, predictable regulatory regimes and growing local capital market funding to use foreign currency financing only to the extent it can be serviced, given the long term record of local currency depreciations.   

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