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The “Raison d’être” of State-Owned Development Banks and

Recommendations for Successful Development Banking

(July 2015)

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Abstract

In this paper we explore the “raison d’être” of State-Owned Development Banks (DBs). They are

important public tools to implement structural policies (in (i) economic, (ii) ecological and (iii)

regional/social respect), (iv) promote the development of the financial sector, (v) facilitate good

governance, peace and stability, and (vi) mitigate economic and other crises. Their theoretical

legitimation is derived from the correction of different types of market failures (externalities,

informational asymmetries), lacking markets or politically undesired market outcomes (social or

regional imbalances). They use different instruments ranging from tailor-made long-term finance

(mainly grants and concessional long-term loans) via diverse forms of mobilizing private funds

(equity, guarantees, structured funds) to expert advice and technical assistance.

DBs have proven to pursue their broad developmental purpose efficiently if properly managed. If

not, however, they may be politically abused and crowd out the private sector. Although the

individual recipes for success are very much context specific, we outline guiding principles whose

application helps DBs to live up to expectations: If a statutory guarantee enables them to

favorably refinance their promotional lending at (inter-)national financial markets they can

generate promotional effects even without tapping scarce public funds. Profit retention is another

important means to facilitate their operations. A precise mandate, sound legal and regulatory

foundations and well-defined corporate governance structures contribute to political

independence and a steady focus on predefined core tasks. Adhering to the principles of

subsidiarity and “on-lending” (i.e. acting as a second-tier bank; in the case of highly standardized

and low-risk promotional programs), supports the market conformity and competitive neutrality of

DBs. By offering tailor-made financial packages, i.e. a suitable combination of advice and

financial instruments with different degrees of concessionality, they can make very efficient use of

public funds, crowd-in private capital and avoid windfall profits.

We conclude that properly designed and managed DBs can be a key tool to efficiently deliver

public policy in the decades to come and to finance the enormous investments required to

achieve the Sustainable Development Goals.

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1. Introduction State-Owned Development Banks (DBs) play an important role in the economy and politics of many developing and industrialized countries. On behalf of their shareholders (usually national and/or subnational governments), they promote the various facets of development – primarily regional economic, environmental and social progress, climate protection, good governance, peace and stability and the mitigation of economic and other crises. Key features of their activities are a broader developmental purpose of their interventions, subsidiarity to the private sector and long-term maturities. The existence and means of operation of DBs are by no means undisputed. Some praise them as very efficient tools to spur development in situations where (i) markets fail, (ii) positive or negative social externalities prevail and/or (iii) undesired market outcomes such as certain degrees of inequality need to be corrected. Others, however, condemn DBs as instruments of market distortion and state interventionism (with DBs being particularly prone to political capture and mission creep). There are plenty of examples to support either the one or the other perspective. Most multilateral DBs, as well as many regional, national and bilateral ones enjoy a high reputation among development experts and politicians. The latter perceive them as useful or even indispensable development financers. The foundation of new DBs like BRICS’ New Development Bank (NDB) and the Asian Infrastructure Investment Bank (AIIB) shows that DBs are on the rise. At the same time there is a history of some failed institutions particularly in some developing countries, though many developing and emerging countries have also had successful DBs. Poorly managed DBs can do more evil than good. But what makes the difference? How should DBs operate in order to become success stories? What legitimizes their existence and in which ways can they contribute to development? This paper aims at answering these questions. The argument is illustrated by real-world examples from Germany’s KfW Group, which is often referred to as a “good practice” example for a very efficient DB which operates both domestically and internationally.

1 Box 1 provides a quick introduction to the

Group, its financial order of magnitude, activities and history. Certainly, the experiences of KfW –like those of any other DB– are to some extent context specific and should therefore not blindly be transferred to other countries. But the Bank’s broad spectrum of promotional activities is well suited to illustrate the numerous purposes and instruments of DBs. Moreover, some guiding principles of efficient development banking which apply in any context can be depicted using KfW’s institutional setup and means of operation. This paper is structured as follows: Chapter 2 comprises (a) the definition of DBs used in this paper, (b) a quick overview of how their purposes and their public and academic perceptions changed over time, and (c) an introduction to the scope of instruments at their disposal. Chapter 3 explores the six key tasks of DBs, namely the promotion of (a) economic development; (b) climate and environmental protection; (c) social and regional development; (d) financial sector development and financial inclusion; (e) good governance, strong institutions, peace and stability; as well as (f) financial stability during macroeconomic crises. It explains the theoretical foundations legitimizing each task. Chapter 4 outlines guiding principles of successful development banking in terms of (a) refinancing mechanisms, (b) the organizational setup, as well as (c) market conformity and (d) the application of banking standards without jeopardizing the developmental objectives of DBs. Finally, chapter 5 summarizes and concludes.

1 The terms KfW Group and KfW are henceforth used interchangeably.

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Box 1 - KfW Group at a glance

On behalf of the German Government the state-owned KfW Group facilitates development both

at home and abroad. It places particular emphasis on addressing challenges of structural

transformation, climate change and environment, globalization and technological progress, as

well as demographic change. Domestically its promotional activities comprise the financing of

Small and Medium Enterprises (SMEs) and startups (primarily investments including innovation,

as well as climate and environmental protection within companies, i.e. renewables, energy

efficiency, etc.) and private customers (among others energy-efficient construction and

refurbishment of residential buildings, renewable energy, barrier-free housing and educational

finance), as well as municipalities (communal infrastructure and environmental protection).

Internationally, KfW Group comprises the bilateral “KfW Development Bank” (carrying out

Germany’s bilateral public Financial Cooperation, financing investments on concessional terms

in developing and emerging countries), and the subsidiary “Deutsche Investitions- und

Entwicklungsgesellschaft“ (DEG; promoting private sector development), as well as the

subsidiary IPEX (financing exports and projects on commercial terms in the interest of the

German and European economy, protecting the environment and securing the supply of raw

materials). KfW also funds programs for national and regional development banks abroad. KfW

Group holds assets worth EUR 489 billion (in 2014). This makes it one of the largest DBs in the

world or, as Luna-Martínez and Vicente (2012) call it, a “megabank”.1 It has more than 5,300

employees and 80 cooperation offices and representations around the world. In 2014 the Group

committed a total of EUR 74.1 billion (see table 1). To put this figure into perspective, this is

about 38% more than total commitments of the World Bank Group.2

Table 1: Business activities of KfW Group in 2014 (commitments in billion EUR)

Domestic promotional

business

SME finance 19.9

Private customers and municipalities 27.7

Subtotal 47.6

International business

IPEX 16.6

KfW Development Bank 7.4

DEG 1.5

Subtotal 25.5

Business sector capital markets 1.2

TOTAL 74.1

Most domestic promotional programs are channeled via first-tier banks (on-lending procedure)

so KfW needs no branch network.3 Furthermore, KfW does not offer customer or deposit

accounts. It refinances its lending activities mainly in the international financial markets. It

benefits from a statutory guarantee of the German Government and associated top long-term

ratings of AAA (Fitch and Standard & Poor’s) and Aaa (Moody’s) which allow it to issue bonds at

very favorable terms. In 2014 its refinancing volume mounted up to EUR 57.4 billion.4 Funds

from the financial markets are supplemented by budget funds from the German Government for

activities requiring an additional subsidy, i.e. a higher degree of concessionality (innovation and

startup finance, development assistance, etc.).

1 It belonged to a group of merely four out of 90 surveyed national DBs with more than USD 100 billion in assets in 2009 (Luna-Martínez and

Vicente, 2012). 2 Commitments of the World Bank Group totaled USD 65.6 billion (i.e. EUR 53.8 billion at the exchange rate USD 1 to

EUR 0.82) in 2014 (World Bank, 2014). 3 An important exception is educational finance for retail customers. 4 In 2014 KfW Group issued bonds in EUR (44.9%), USD (37.8%), JPY and GBP (both 5.3%) and other currencies.

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2. State-Owned Development Banks: What they are, how they evolved and what instruments they use

a. What are State-Owned Development Banks?

In this paper we define DBs and their subsidiaries as entities with public policy mandates owned by

(sub-)national governments. Their principal objective is to provide long-term finance for the promotion

of national and/or international development on behalf of their shareholders, i.e. the government(s).

For this purpose they use public funds and raise funds from national and international financial

markets (see also sections 2c and 4a). DBs are supposed to finance investments which are not or not

sufficiently funded by commercial financial intermediaries for a variety of reasons (like market failures

and externalities, see chapter 3 for details).

Besides financing developmental activities, the engagement of DBs may also comprise:

administering (trust-)funds from governments and other development agencies;

crowding-in private finance by structuring financing packages and mitigating political and

policy risks as anchor investor;

analyzing developmental constraints and developing suitable solutions to overcome them;

fostering enabling environments, policy frameworks, ownership and accountability;

assessing project proposals with respect to their expected developmental impacts and risks;

knowhow transfer and provision of technical advice (technical design, tender procedures,

cost, time-, and contract management);

facilitating local capacity development with respect to the design, implementation,

maintenance and operation of the investment;

assuring economically efficient, and environmentally and socially sound project

implementation (risk-management, safeguards, monitoring and evaluation); and,

on the liabilities side, raising funds from (inter-)national financial markets to refinance their

commitments (see sections 2c and 4a).

DBs differ from commercial banks with respect to their objective (promotion of sustainable

development instead of profit maximization). They differ from other development agencies with respect

to their instruments (focus on providing finance for investments in the public interest). Being a bank,

they are not restricted to the use of private donations or public funds, but they can tap (inter-)national

financial markets and apply banking principles and know-how to overcome development obstacles.

The following types of DBs are addressed in this paper:2

National Development Banks (commonly referred to as promotional banks) usually limit their

activities to the territory of their owners. They tend to concentrate on the promotion of the

domestic economy, environmental protection, communal infrastructure, housing and

education. Loans, sometimes with a targeted concessional element, are their main

promotional instrument, though they also use equity, grants and other instruments in some

cases. Examples include the Small Industries Development Bank of India, the Banco Nacional

do Desenvolvimento (BNDES) in Brazil and the Banco del Estado de Chile in developing and

emerging countries, as well as the British Business Bank and the Spanish Instituto de Crédito

Oficial in industrialized countries.

2 National and bilateral DBs are by far the largest group in this list. Many of them are organized in the International Development Finance Club (IDFC). In 2010 the commitments of the formerly 19 (nowadays 23) IDFC members added up to approximately USD 390 billion. Total assets exceeded USD 2,100 billion. For a more detailed taxonomy of state-owned financial institutions see Gonzalez-Garcia and Grigoli (2013) who differentiate between four categories: (i) retail commercial banks, (ii) development banks, (iii) quasi-narrow banks, and (iv) development agencies.

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Bilateral Development Banks invest in developing and emerging countries to promote

sustainable development in a broad range of sectors. Their instruments range from grants and

concessional loans, commonly combined with technical assistance and advice, to more

complex tools such as structured funds and securitization. Under certain conditions defined by

the Development Assistance Committee of the OECD these investments are regarded as

“Official Development Assistance” (ODA). Examples of bilateral DBs are the Agence

Française de Développement and the Japan International Cooperation Agency.

Regional Development Banks (such as the African Development Bank, Corporación Andina

de Fomento (CAF) and Banco Centroamericano de Integración Económica (BCIE)) and

Multilateral Development Banks (such as the World Bank) perform similar functions and use

similar instruments as bilateral DBs. In contrast to the latter they are owned by a group of

countries.

Moreover, there are so-called Development Finance Institutions (DFIs) which specialize in the

promotion of the private sector in developing and emerging countries. Although they finance at (close

to) market conditions they pursue broader developmental objectives and do not compete directly with

private banks. Their activities are usually medium- to long-term and take place in relatively high-risk

environments where the private offer of capital is scarce. Preferred instruments are long-term loans,

equity, mezzanine finance and guarantees coupled with technical assistance and other non-monetary

support. Examples for bilateral DFIs are Proparco from France and FMO from the Netherlands.3 A

prominent multilateral example is the International Finance Corporation (IFC) of the World Bank

Group.

Some DBs have a hybrid mandate, integrating different types of institution. An example is KfW Group,

which acts on behalf of the German Government as national DB in Germany and as bilateral DB in

developing and emerging countries. Moreover, KfW’s subsidiary, DEG, is a bilateral DFI.4

In the remainder of this paper the abbreviation DB generally refers to each of the three types of DBs

mentioned above. If a particular type of DB or a DFI is addressed, this is stated explicitly.

b. Changing Purposes of and Views on State-Owned Development Banks

The debate on how and to what degree DBs can efficiently contribute to development is anything but

new. Over time both the problems they were supposed to solve and associated perspectives on their

usefulness evolved. In the first half of the 20th century catastrophic events often were the catalyst for

the foundation of DBs. Chile’s Corporación de Fomento de la Producción (Corfo), for instance, was

established after a devastating earthquake in 1939. Similarly, the destruction of World War II triggered

the foundation of DBs in Continental Europe and Japan. Accordingly, the initial purpose of these

institutions was the financing of reconstruction. They are said to have been crucial for accomplishing

this task, as well as for facilitating (re-)industrialization (Cameron 1961; Armedariz de Aghion 1999).

In the 1950s, 60s and 70s the concept of DBs took hold in more and more countries across the world.

Especially in developing countries they were supposed to match scarce capital with abundant labor. If

their most pressing purpose was not reconstruction, it was broader economic development and

structural change, i.e. the promotion of infrastructure, industrialization, and growth. The rise of DBs

3 Both are members of the Association of European Development Finance Institutions consisting of 15 bilateral DFIs. 4 KfW Group also comprises its subsidiary IPEX-Bank which is in charge of international project and export finance. This subsidiary is not relevant in the context of this paper, because it is a public commercial, as opposed to a development bank.

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was underpinned by the so-called “development view”. It regards DBs as useful for financing the

development of certain sectors and/or regions which are neglected by private banks (Gerschenkron,

1962). Also, big-push theories (e.g. Rosenstein-Rodan, 1961) are in line with DBs being important

financiers of economic transformation.

Later the development view was complemented by the so-called “social view”. It focuses on

investments with positive social externalities which are not financially profitable for – and hence

underfinanced by – private actors (Atkinson and Stiglitz 1980; Stiglitz 1994). For example, education,

health and social safety produce substantial positive externalities and therefore they may warrant

public intervention and more precisely the engagement of DBs. With the emergence of the social view

DBs increasingly tackled social issues additionally to economic ones. Particularly regional, bi- and

multilateral DBs shifted their focus more and more to poverty reduction and social development from

the beginning of the 1990s onwards. Since then the perception of positive externalities that DBs can

tackle has been broadened, especially to the environmental field, given the key aim of climate change

mitigation and adaptation.

Simultaneously and fuelled by the neoliberal economic policies of the Washington Consensus and the

collapse of the Soviet Union a more critical view on DBs emerged in the 1980s and 90s. Particularly

national DBs were regarded by many as an instrument of unacceptable state interventionism.

Especially in weak political and institutional environments they were heavily criticized because of

mission creep, mismanagement and inefficiencies. Consequently, many national DBs were dissolved

or (partly) privatized in the 1990s (World Bank, 2012). In 2001 the World Bank stated that “state

ownership of banks tends to stunt financial sector development, thereby contributing to slower

growth.” (World Bank, 2001) The underlying rationale behind this critique is expressed in the so-called

“political view”. It contends that national DBs are easily (and commonly) abused by politicians who

exploit them for personal goals such as reelection and enrichment (La Porta, Lopez-de-Silanes, and

Shleifer, 2002). Typical abuses include politically influenced and highly subsidized commitments in

favor of the ruling party and its supporters, combined with sluggish recovery of outstanding payment

and generous debt relief, resulting in enormous deficits of DBs and frequent requests for

recapitalization .5

The popularity of DBs gained ground again when the Millennium Development Goals (MDGs) were

adopted by the United Nations in 2001. One year later the International Conference on Financing for

Development agreed upon the Monterrey Consensus which pointed out how the goals should be

financed. Internationally operating DBs were (and are) supposed to play an important role in this

regard.6 The predominantly social focus of the MDGs further contributed to their orientation towards

issues of social development such as poverty reduction, education and health.

DBs experienced another push during the global financial crisis starting in 2007/08 when commercial

banks curtailed their lending operations. Practically all DBs cushioned the macroeconomic shock by

providing countercyclical funds to the private sector. This helped to secure hard won economic

development gains and spurred recovery in both the financial sector and the real economy (World

5 In the academic literature there is also the so-called agency view: “The agency view is somewhere in between the benign view of state intervention in the banking sector, as represented by the social and development views, and the more cynical political view. … The agency view emphasizes that although market imperfections may exist, agency costs within government bureaucracies may more than offset the social gains of public participation.” (IADB, 2005) 6 Paragraph 18 of the Monterrey Consensus states, among others (United Nations, 2003): “Development banks … can be effective instruments for facilitating access to finance, including equity financing, … as well as an adequate supply of medium- and longterm credit.” Paragraph 45 is explicitly dedicated to regional and multilateral DBs: “Multilateral and regional development banks continue to play a vital role in serving the development needs of developing countries and countries with economies in transition. They should contribute to providing an adequate supply of finance to countries that are challenged by poverty, follow sound economic policies and may lack adequate access to financial markets. They should also mitigate the impact of excessive volatility of financial markets. Strengthened regional development banks and subregional financial institutions add flexible financial support to national and regional development efforts, enhancing ownership and overall efficiency. They also serve as a vital source of knowledge and expertise on economic growth and development for their developing member countries.”

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Bank, 2012). Countercyclical lending by DBs is backed by the so-called “macroeconomic view”

arguing that positive externalities of increasing credit supply during a crisis justify public intervention

(Bonomo et al., 2014).

All in all, views on DBs changed significantly over time and were substantially influenced by their track

record and the development of economic theory. The particular purposes of DBs have been and

remain context specific. At the same time they tend to expand and become more complex: In addition

to reconstruction, economic and social development and the mitigation of the impact of financial crises

they address topics such as climate change, environmental protection and the provision of national

and global Public Goods7. The discussions about financing the Sustainable Development Goals

(SDGs), replacing the MDGs after 2015, and the enormous global investment gap8 suggest that DBs

will continue to play a key role in financing development.

c. Instruments of State-Owned Development Banks

Against the background of increasingly complex functions DBs have developed a sophisticated set of

instruments. They analyze the developmental usefulness and risks of projects and assess

developmental strategies and concepts, institutional frameworks and the needs of beneficiaries. They

have broad know-how in the implementation, monitoring and evaluation of projects under different

regional, natural, social and cultural circumstances. They introduce and monitor social, environmental

and “responsible finance” standards. Moreover, many DBs are equipped with a statutory guarantee

from their state owner(s) allowing them to borrow at very favorable rates on (inter-)national financial

markets (see section 4a). Combining financial market funds with public budget allocations enables

them to perfectly adapt their financing terms to the specific needs of a particular project. In other

words, DBs are able to offer a package of tailor-made financial solutions and advice:

Long-term finance: The provision of long-term finance is in many ways the standard

approach of DBs (and DFIs). Respective instruments are grants and loans (concessional and

non-concessional), as well as equity and mezzanine finance.

Equity and mezzanine finance is particularly used for long-term investments in principally

profitable businesses and financial institutions. On the other hand, grants are often used for

recipients who lack the ability to service debt and projects which have no immediate financial

return like basic education and health services.

Concessional loans are provided at more favorable conditions than those offered by private

financial institutions (e.g. lower interest rates, longer maturity, longer grace periods or less

collateral). The degree of concessionality can be adjusted to the specific needs of a particular

project on a sliding scale between “almost grant” (highly concessional) and “almost market

terms” (lowly concessional). The appropriate degree depends on both the financial return of

the project and the financial capacity of the debtor. The higher the return of the project and the

financial capacity of the borrower, the less concessional a loan should be.

The degree of concessionality is measured by the “grant element”, i.e. by the present value of

the advantage of the concessional loan over financing conditions on private financial markets.

The grant element ranges between zero (zero concessional) and one (fully concessional, i.e.

grant) and resembles a subsidy (i.e. a “donor effort”).9 For highly concessional loans DBs

usually require funds from public budgets. For lowly concessional loans it may be sufficient if

7 By definition a Public Good is both non-excludable and non-rivalrous. That is, individuals cannot be effectively excluded from its consumption. Moreover, its consumption by one individual does not reduce its availability to another individual. Typical Public Goods financed by DBs are, for instance, public infrastructure such as roads, as well as clean air, a stable climate, biodiversity, security etc. 8 According to UNCTAD’s World Investment Report 2014 “global investment needs are in the order of $5 trillion to $7 trillion per year.” (UNCTAD, 2014) It estimates that the annual financing gap in developing countries alone ranges from USD 3.3 to 4.5 trillion, “mainly for basic infrastructure (roads, rail and ports; power stations; water and sanitation), food security (agriculture and rural development), climate change mitigation and adaptation, health, and education.” 9 By contrast, the liquidity, i.e. the face value*(1-grant element), is generated by DBs issuing bonds on (inter-)national financial markets.

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DBs use their privileged financial market access. In this case they merely pass on the

advantage which they enjoy as a quasi-public borrower on (inter-)national markets to the

recipient. The capability of DBs to generate a promotional effect without tapping public

budgets makes them a highly appreciated promotional instrument for many governments

(assuming that DBs do not accumulate poor risks which could revert to public budgets in case

of bailout or bankruptcy of the DB).

Table 2 presents a simplified overview of how regional, bi- or multilateral DBs tailor degrees of

concessionality to specific investment needs.

By carefully determining the grant element (irrespective of whether it is generated by explicit

public subsidies, risk absorption by DBs or a combination of both) DBs are able to ensure the

efficient use of public funds and to avoid “over-promotion”, i.e. windfall gains for the debtor.

The avoidance of over-promotion is also crucial for not crowding out the private financial

sector.

Table 2: Simplified overview of tailoring degrees of concessionality to investment needs

1

Financial capacity of debtor

LOW HIGH

Retu

rn o

n in

ve

stm

en

t

LO

W

Instrument: pure grant Grant Element: equal to 1

Application: projects in fragile and/or poor countries targeting the poorest share of the population and/or social sectors; projects with positive externalities Examples: primary education, basic health, global Public Goods like biodiversity

Instrument: concessional loan Grant Element: between 0 and 1

2

Application: projects in more advanced and stable countries targeting the poorest share of the population and/or targeting social sectors; projects with positive externalities Examples: urban water supply, waste disposal, energy efficiency, global Public Goods like biodiversity

HIG

H

Instrument: concessional loan Grant Element: between 0 and 1

2

Application: projects in fragile and/or poor countries targeting profitable sectors and/or certain types of infrastructure Examples: energy, transportation, microfinance

Instrument: loan at market rate Grant Element: equal to 0

Application: projects in more advanced and stable countries targeting profitable sectors and/or certain types of infrastructure (usually financed by private sector or potentially DFIs) Examples: agro business, textiles

1 With respect to regional, bi- or multilateral DBs lending abroad. 2 The sliding degree of concessionality allows for optimal tailoring of financial conditions to investment needs.

Mobilizing private funds: Rather than providing all necessary funds themselves (from financial markets or public budgets) DBs often aim at mobilizing private capital for development. The basic idea is to increase the attractiveness of investments for the private sector by reducing financing cost, sharing risks and providing information. The group of associated instruments comprises mainly the provision of loans, equity, mezzanine finance, asset-backed lending, securitization, guarantees, co- and parallel financing arrangements, syndicated loans and various forms of public-private partnerships. Larger investments often require finance solutions which are structured in different risk-return layers incentivizing investors with different risk profiles. In this case DBs typically engage in more risky junior tranches to crowd in private capital in less risky senior tranches.

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10 For a detailed description of these instruments see chapter 11 of OECD (2014). Mobilizing private capital is all the more important as global investment needs ostensibly amount to USD 5 to 7 trillion per year (see above), on the one hand, and a large part of private funds is not channeled to according investments, on the other. For example, the mere 2% of sovereign wealth fund assets, totaling USD 5 trillion, so far invested in sustainable development projects are negligible (UNCTAD, 2012).

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Whenever it is intended to mobilize private funds, particular care must be taken not to generate windfall gains for the private sector: The incentives given to private investors should be confined to the extent which is just necessary to get them involved and the developmental purpose achieved.

Providing advice and technical assistance: Usually non-financial instruments accompany financial ones. For example, DBs provide a wide range of advisory services and technical assistance, build track records in new sectors and projects (market development), strengthen partner institutions’ capacity of handling investments sustainably, as well as set and monitor important standards such as social and environmental, as well as responsible finance standards. Furthermore, they typically offer: in-depth country- and sector analyses; needs assessment; institutional-, peace and conflict analyses; financial and cost-benefit analyses; assistance in defining project goals; assistance in technical design and choice of technology; feasibility studies; environmental-, climate- and social impact assessments; advise and support in implementing complex projects (governance structure, tender and disbursement procedures, transaction management, corruption control measures, community participation and grievance mechanisms); monitoring and evaluation mechanisms.

3. Six key tasks of State-Owned Development Banks

This chapter presents the six key tasks of DBs (which are not mutually exclusive): DBs implement structural policies in (a) economic, (b) ecological and (c) regional/social respect; they (d) promote the development of the financial sector, (e) good governance, peace and stability; and (f) they mitigate economic and other crises. The chapter separately introduces each task and highlights the underlying rationales for intervention (see summarizing table 3).

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The justifications for public action do not aim at being all-encompassing but rather provide an overview of the most important points. The different functions outlined here generally can be assumed by national, regional, bi- and multilateral DBs (though the institutions often concentrate on specific tasks as explained below). Each task can be addressed by using different promotional instruments (as outlined in section 2c), but the use/usefulness of instruments varies between the six tasks (see overview in table 4). This variation is explained in the following subsections of this chapter. The discussion is flanked with boxes containing appropriate examples of programs implemented by KfW on behalf of the German Government at home and abroad. a. Structural Policy I - Economic Development

A vibrant private sector is indispensable for economic development. Private firms innovate and offer jobs and income. They produce goods and services demanded by consumers. They contribute to the public provision of social services and Public Goods by paying taxes. At the same time, they depend on governmental institutions and policies that facilitate doing business. A basic principle of market economies is “creative destruction” as the famous Austrian economist Joseph Schumpeter put it, implying that newcomers must have a chance to challenge existing firms by introducing better products or more efficient production processes. This entails that less efficient firms are forced out of the market.

11 Rationales for interventions such as market failures, undesired market outcomes, information asymmetries, externalities, etc. are necessary but not sufficient conditions for the existence of DBs. Alternative market interventions are regulations, subsidies, taxes and allowances, among others. A detailed comparison of DBs with other types of interventions is, however, well beyond the scope of this paper.

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Table 3 – Six key tasks of development banks

Key tasks Rationales for intervention

a Structural Policy I -

Economic Development

No “level playing field” between firms of different size

Structural disadvantages of startups

Uncertainty and positive externalities of innovation

Public Good character and positive externalities of economic infrastructure

b

Structural Policy II - Mitigation of and

Adaptation to Climate Change, Resilience and Environmental Protection

Negative externalities

High upfront costs, long amortization

Public Good character and positive externalities of resilience increasing infrastructure

Lack of alternative income sources

Shortsighted behavior

c Structural Policy III - Social and Regional Development

Basic Human Rights

Positive externalities

Undesired market outcomes

(Multiple) market failures

d Financial Sector

Development and Financial Inclusion

Market failure arising from asymmetric information

Market failure arising from moral hazard

Missing collateral (failing land markets)

High transaction costs

Elevated medium- and long-term risk

e

Promoting Good Governance, Strong

Institutions, Peace and Stability

Forgone revenues/high costs of bad governance and poor institutions

Insufficient capacity at lower levels of government

Short-run consequences of civil conflicts and wars

Medium- to long-run consequences of civil conflicts and wars

f Fostering financial stability by playing a countercyclical

role

Insufficient private credit supply during a crisis

More prudential regulation in response to financial turmoil

General volatility of financial markets

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Table 4: Overview of use/usefulness of different promotional instruments for specific tasks of DBs

Instruments

Tasks

Grants1

Concessional

loans2

Loans at

market rates

(long-term)3

Equity and

mezzanine

finance

Instruments

to mobilize

private funds

Advice and

technical

assistance

Structural Policy I -

Economic Development ++ +++ +++ +++ +++ ++

Structural Policy II -

Mitigation of and

Adaptation to Climate

Change, Resilience and

Environmental

Protection

+++ +++ ++ + ++ +++

Structural Policy III -

Social and Regional

Development

+++ +++ + + + +++

Financial Sector

Development and

Financial Inclusion

++ +++ ++ +++ +++ +++

Promoting Good

Governance, Strong

Institutions, Peace and

Stability

+++ +++ + + + +++

Fostering financial

stability by playing a

countercyclical role

++ +++ +++ + +++ +

Key: +++ instrument is (very) commonly used/very useful for task; ++ instrument is used/useful for task; + instrument is little or not used/useful for

task

1 Projects in fragile and/or poor countries targeting the poorest share of the population and/or social sectors; projects with positive externalities

(see table 2).

2 Projects in more advanced and/or stable countries targeting the poorest share of the population and/or targeting social sectors; projects in fragile

and/or poor countries targeting profitable sectors and/or certain types of infrastructure; projects with positive externalities (see table 2).

3 Projects in more advanced and/or stable countries targeting profitable sectors and/or certain types of infrastructure; key difference to private

credit is long-term maturity (see table 2).

The state must assure a smooth functioning of the market by providing efficient economic institutions

(e.g. markets, social protection, rule of law), assuring fair competition and an enabling environment for

private entrepreneurs (like access to markets, energy and finance). Structural policy aims at providing

and maintaining these conditions, while at the same time assuring that the benefits are adequately

spread among the different regions and layers of society. DBs are often used as market-conform

instruments of structural policies in order to counteract distortions which the market process might

create. Typical problems which DBs might mitigate in the field of economic development are the

following:12

, 13

No “level playing field” between firms of different size: A fair competition among firms is often

hampered by economies of scale which are exploited by large firms but not achievable for SMEs. This

concerns not only the production side, but also the financing of investments: Large firms are preferred

customers of banks and may even directly tap financial markets by issuing bonds and shares. SMEs

12 DBs promote economic development also via supporting financial sector development, good governance and strong institutions, among others (see 3d and 3e). 13 When promoting economic development (particularly regional, bi- and multilateral) DBs complement financial with non-financial support. Typical services include capacity building, technical assistance and a wide range of advisory services (feasibility studies; environmental, climate and social impact assessments; institutional, cost-benefit, peace and conflict analyses; etc.).

13

often suffer from limited access to affordable credit because the transaction costs of banks are high in

relation to the financing volume commonly required.14

This reduces competition, growth, income and

job creation in the economy (with SMEs being the main driver of job creation in most market

economies). DBs can contribute to level the playing field particularly by offering concessional and/or

long-term loans to SMEs (see box 2 for an example of KfW’s subsidiary DEG). Other suitable

instruments are, for instance, equity and mezzanine finance.

Structural disadvantages of startups: The process of “creative destruction” is often

hampered by entry barriers for newcomers in the market. These include high upfront and step-

up cost and bureaucratic obstacles. Startups also suffer from limited access to affordable

credit due to even higher transaction costs than SMEs: As they are by definition new to the

market and lack a track record of business banks find it difficult to assess and price the risk of

lending them money.15

The structural disadvantage of startups impairs competition and

dynamism of the economy as a whole. DBs can contribute to reduce this disadvantage by

offering promotional programs for startups, which provide access to finance at adequate

prices.

Uncertainty and positive externalities of innovation: The inherent force of firms to innovate

in order to stay in the market assures that customer needs can be satisfied in higher quality

and/or at a lower price, increasing national welfare. But innovators take technical and financial

risks. They invest large sums and efforts into research and development of new products and

processes without knowing whether the result will be technically functioning and marketable.

Even if the product is marketable, it is questionable whether they can recover the initial cost

before imitators copy the idea (patent laws may provide imperfect protection against this).

Banks are particularly hesitant to finance innovations as they find it difficult to assess the risk

involved. These imperfections may lead to innovation rates well below the national/social

optimum.

Adequate innovation rates are also hampered by positive externalities: Not only the

innovator himself but also the economy as a whole benefits from innovations, as they are

often used as a stepping stone for even more sophisticated products. DBs can help to

overcome the structural innovation deficit by providing finance to innovators at favorable

terms.

Public Good character and positive externalities of economic infrastructure:16

, 17

Public

infrastructure such as transport (roads, railways, ports, airports), telecommunications, energy,

water, etc. improves the operating conditions and competitiveness of private enterprises and

is sometimes even a “conditio sine qua non” for private activities. The rate of economic return

is typically high, but – because of its Public Good character, high upfront costs, etc. – such

investment is often underfinanced by the private sector. DBs can help to overcome this

development constraint by providing finance for this type of infrastructure. In this context

regional, bi- and multilateral DBs tend to use grants if the recipient is a low-income country.

Besides, DBs can use guarantees and structured funds to channel more private funds into

infrastructure projects with positive developmental effects.

14 According to the recent report of the International Committee of Experts on Sustainable Development Finance (ICESDF) the unmet need for credit of SMEs equals around USD 3.5 trillion globally (ICESDF, 2014). 15 For a more detailed elaboration on this argument related to adverse selection and asymmetric information see section 3e. 16 In the case of financially viable infrastructure such as telecommunication or energy special care must be taken not to crowd out the private financial sector. DBs engagement should be limited to cases where the investment project is too large or too risky for private financial institutions to finance it alone. It is often sufficient if DBs step in as anchor investors signaling the developmental importance and priority of the investment, as well as bringing in their professional experience in thoroughly appraising the project and sharing risk (see section 4c). 17 Often DBs are also used to promote the development of certain sectors within the economy (e.g. export industry or agriculture). However, successful sector picking is a controversial issue in Economics. By contrast the promotion of SMEs, startups, innovation and infrastructure is more generally accepted.

14

Box 2 - Supporting private sector development in Kenya

DEG, a subsidiary of KfW, finances investments of private companies in developing and

emerging market countries. DEG’s aim is to establish and expand private enterprise structures,

and thus create the basis for sustainable economic growth and a lasting improvement in the

living conditions of the local population. This support is motivated by the fact that the private

sector is by far the most important driver of economic development.

One of the clients of DEG is Kevian Kenya Ltd. which was founded some 20 years ago and

produces mineral water and juices. Long-term funding is crucial for Kevian to modernize its

machinery, stay competitive and expand its operations. However, private financial institutions in

Kenya – as in many other developing countries – do not tend to offer this type of financing

Against this background, DEG supplied Kevian with a long-term loan of USD 7.5 million in 2012.

The company used the resources, among others, to improve its packaging and bottling systems.

It also entered into fruit processing and the production of fruit juice concentrates. The latter are

used for producing juices and have mostly been imported previously. DEG and foreign

customers of Kevian closely cooperate with the enterprise in establishing and implementing

sound environmental and social standards. They further promote capacity building of employees

of Kevian, transferring know-how and ensuring reliable maintenance and operations.

DEG’s loan unlocked the potential of the Kenyan business: Today Kevian employs about 300

people. It has become an international player exporting not only to other East African countries

but also to Europe. Backed by its new production capacities Kevian now purchases the

production input, i.e. fruits and vegetables, directly from some 30,000 smallholders across

Kenya. Farmers who used to produce at the subsistence level beforehand have been included

into a new and more profitable value chain. Their income is not only boosted but also stabilized

as Kevian is a predictable buyer of their produce both in terms of price and quantity.

b. Structural Policy II – Mitigation of and Adaptation to Climate Change, Resilience and Environmental Protection

Climate change and environmental degradation harm societies all over the world. They provoke global

warming and ensuing weather extremes, the loss of biodiversity, desertification, deforestation,

pollution of oceans and freshwaters, etc. Besides the ecological, the economic and social impact can

be disastrous. For instance, people may be forced to migrate and lose their income source due to

natural disasters like a drought. The issues are on top of political agendas both at the international and

at the national level. Examples include the Post-2015 Agenda with its Sustainable Development Goals

and the UN Framework Convention on Climate Change. DBs are often key institutions for the

implementation of respective structural policies in this field.

The following aspects justify public intervention to handle climate change and its consequences, as

well as to protect the environment:

Negative externalities: Markets do not always internalize all effects of economic activities.

Consequently, prices may not adequately reflect their actual costs (or benefits) entailing

suboptimal market outcomes. For instance, producing energy from fossil fuels creates CO2

emissions which propel climate change, i.e. a negative externality not accounted for in most

cases. Investment in renewable energy does not generate such externality and may therefore

–from an economic and environmental point of view– be a better solution. Likewise the

promotion of energy efficiency reduces unaccounted CO2 emissions and contributes to pave

the way towards a low-carbon economy. DBs can incentivize this kind of economically and

15

environmentally useful investment by providing enterprises, private individuals and public

entities such as municipalities with concessional loans (or “green” credit lines at below market

rates via financial intermediaries; see box 3 for how KfW promotes energy efficiency in

Germany and Mexico).18

If the recipient is a low-income country regional, bi- and multilateral

DBs tend to use grants for supporting “green” projects. Their financial engagements are often

flanked by non-monetary support such as the introduction of environmental standards.19

In

more complex cases DBs may structure “green” financing packages, combining contributions

from different public and private sources and serving as anchor investors themselves. In

addition, they may raise capital for climate or environment-related projects by issuing thematic

bonds on (inter-)national financial markets.

High upfront costs, long amortization: Investing in climate and environmental friendly

infrastructure, housing, production sites, etc. often implies high upfront costs. At the same

time, projects such as refurbishing buildings to become energy efficient take a long time until

their break-even point is reached. DBs address these obstacles by providing financing

solutions with initial grace periods and long maturities.

Public Good character and positive externalities of resilience increasing

infrastructure:20

Flood shelter, embankments, reservoirs and other resilience increasing

infrastructure facilitate development because they stabilize long-run development paths. They

are Public Goods with high rates of economic return which usually cannot be internalized by

the private sector. DBs can help to stabilize long-run development paths by financing

resilience-strengthening infrastructure via concessional loans and/or grants.

Lack of alternative income sources: The unsustainable exploitation of natural resources

such as excessive logging frequently goes hand in hand with a lack of alternative income

sources. In this context DBs can assist by promoting more sustainable land-use techniques or

implementing alternative private sector development and employment schemes.

Shortsighted behavior: Individuals may be unable or unwilling to consider the disastrous

long-term effects of climate change and environmental degradation and to link them to their

own behavior. DBs may promote sensitization and information campaigns and introduce

economic incentives and other nudges to redirect behavior.

18 Besides own and national funds, DBs may use resources from global initiatives such as the Green Climate Fund for climate-related investment in form of concessional loans and grants. 19 Prominent other examples at the international level include the organized transfer of clean technology and technical assistance. Furthermore, DBs usually advise private financial intermediaries in lending for energy efficiency, renewables, and other environmental investments. 20 Physical infrastructure is not the only means to increase resilience with respect to weather calamities etc. Particularly the financial sector with insurance products of different types likewise plays an important role.

16

Box 3 - Investing in energy efficiency and “exporting” longtime expertise

KfW has a long history of contributing to the reduction of CO2 emissions by promoting, among

others, energy efficiency.1 Already in the 1970s it established respective domestic lending

programs in response to global oil price rises. KfW’s promotional approach is to offer long-term

loans with fixed, below market interest rates and an initial grace period for well-defined

investments in energy efficiency. For example, the bank finances pre-defined refurbishment

packages which all are in line with the so-called “KfW-Efficiency-House” standards which have

become broadly applied efficiency benchmarks for residential buildings in Germany. Commercial

banks are used (and paid) for on-lending the loans, i.e. passing them on, to the final customer.

KfW also offers small grants of up to 10% of the investment cost (and up to a maximum grant of

EUR 18,750 per housing unit) for private refurbishments according to its efficiency standards. In

2013 KfW’s “Energy-Efficient Refurbishment” program for residential buildings had a

commitment volume of over EUR 4.1 billion (composed of some 116,000 individual

commitments). KfW-funded refurbishments lower Germany’s CO2 emissions significantly. For

instance, they are said to have contributed greatly to the estimated 24% reduction of CO2

emissions of the existing building stock between 1990 and 2006 (Schröder et al., 2011).

Resorting to this longtime promotional know-how KfW facilitates similar endeavors abroad. In

Mexico, for example, the national DB "Sociedad Hipotecaria Federal" implements the

governmental program EcoCasa. Following the German example, EcoCasa establishes energy

efficiency standards for residential buildings which it finances via promotional loans or grants.

Together with the Inter-American Development Bank and others KfW supports the program. The

German contribution totals around USD 117 million (in form of a low-interest loan and

investment subsidies). EcoCasa will run for seven years and particularly targets poor

households. It aims at mobilizing a total of USD 500 million for private investment, as well as

constructing over 38,000 energy efficient houses and 600 passive houses (i.e. houses with

sophisticated insulation which do not need an extra heating unit). Over the entire lifecycle of the

houses some one million tons of CO2 emissions are supposed to be saved. Moreover, it is

expected that the efficiencies standards set by EcoCasa will leave their footprint in the domestic

real estate market in the medium- to long-run. According to the Climate Secretariat of the United

Nations (UNFCCC) the program is one (out of 17) lighthouse project within the framework of

international climate protection activities.

1 For a detailed analysis of KfW’s history and promotional activities with respect to domestic energy efficiency see Schröder et al. (2011).

c. Structural Policy III - Social and Regional Development

There is broad political consensus that for humanitarian and egalitarian reasons a certain level of

social services such as education, health, housing and social protection should be offered at

affordable prices to everybody (including at subsidized prices for people who would otherwise not be

able to take advantage of those services; e.g. similar opportunities for children to visit school

irrespective of the income and wealth of their parents). This fosters social cohesion, stability and

security. Some regions, sections of the society or groups may be economically disadvantaged and/or

socially marginalized because of their ethnicity, cultural or religious beliefs, etc. Long-term

developments such as structural change and demographic transition pose additional challenges to

society, like an aging society which requires adequate pension schemes and age-appropriate

infrastructure and buildings. Again, against this background DBs can assume numerous tasks aiming

at social inclusion and regional balance.

17

The underlying rationale for public intervention in social and regional development comprises:

Basic Human Rights: First and foremost, the satisfaction of basic needs such as access to

primary education, basic health services, social protection, nutrition, housing, water and

sanitation are human rights. Related comprehensive and effective social services are the

backbone of healthy societies and market economies. DBs can contribute to satisfy basic

needs by improving access to these services.21

Due to low private returns and the focus on

poorer sections of the society their standard tools for doing so are grants or highly

concessional loans. Internationally DBs may use grants to assist low-income countries in

assuring basic human rights and/or adhering to international agreements such as the

Millennium/Sustainable Development Goals (see box 4 for an example of KfW’s engagement

in education in Kenya).22

Typically DBs also provide non-financial support when promoting

social and regional development.23

Box 4 - Promoting education at home and abroad

KfW strongly engages in supporting education both nationally and internationally. In Germany it

focuses on facilitating lifelong learning which is crucial for upholding welfare and

competitiveness of an aging population. More precisely, the bank finances investments in

municipal social infrastructure such as kindergartens and schools to foster the supply side of

education. Moreover, with credit for tertiary education and vocational training it complements

other public scholarships and loans on the demand side. A case in point is KfW’s “Student Loan”

which enables people of different social strata, backgrounds and age to benefit from university

education: It pays up to EUR 650 monthly and has an initial grace period, flexible repayment and

low interest rates. Eligible for the loan are students of tertiary education, advanced or

supplementary studies, second degree or doctoral studies, as well as part-time studies. In 2013

KfW made more than 33,000 student loan commitments worth almost EUR 1.4 billion.

Likewise, in developing countries KfW combines supply and demand side measures to promote

education. The former include the construction, extension, modernization and rehabilitation of

school buildings, the equipment of educational institutions and the strengthening of vocational

training offers. The latter comprise loans, vouchers and scholarships for education. Together

with other international partners and the Equity Group Foundation KfW finances, for instance,

the “Wings-To-Fly“ scholarship program in Kenya. It offers financial support for high-quality

secondary education, as well as so-called leadership and social transformation sessions

fostering soft skills. There is also a mentoring component which focuses on social responsibility.

The target group are disadvantaged children with outstanding performance in primary school

(belonging to the top 5% percent of their age-group). A sophisticated and transparent screening

process facilitates the successful targeting of children who could not afford high-quality

secondary education otherwise. Important eligibility criteria include the loss of one or both

parents and the poverty status of (foster) parents. That way “Wings-To-Fly“ promotes social

advancement and permeability. KfW provides the program with grants worth EUR 6.4 million.

21 Some basic services, for instance primary education, tend to be delivered free of charge. Others which are expected to have high private returns like water supply or tertiary education usually require some contribution from beneficiaries (in the form of fees or tariffs). Beneficiary contributions are used to ensure sustainable service delivery by covering operational and (part of) capital costs (for maintenance and extensions). 22 In industrialized countries national DBs rather rely on concessional loans which they provide either directly or via financial intermediaries to clients such as students, landlords aiming at refurbishing their (old-)age buildings appropriately, and structurally weak municipalities (see box 4 with respect to KfW’s “Student Loan”). Concessional loans are also used to finance utilities (which generate some income like water and sanitation, waste disposal, energy etc.) in more advanced countries. 23 Related services include the setting of social standards, capacity building, technical assistance and a wide range of advisory services (policy advice, feasibility studies; environmental, climate and social impact assessments; institutional, cost-benefit, peace and conflict analyses; etc.).

18

Positive externalities: As opposed to, for instance, negative externalities resulting from CO2

emissions, social services often produce positive externalities (why they are not merely ends

but also means of development). The intervention of DBs is particularly warranted if positive

externalities are substantial and private returns to investment are unattractive (this also

applies to many of the basic needs cited above). By offering finance at favorable conditions,

DBs can either directly promote this kind of services or (partly) offset the gap between

economic and financial rates of return, in order to attract the private sector.

Undesired market outcomes: Even if markets capture externalities, societies may want to

correct for undesired market outcomes such as very uneven distributions of income, wealth

and opportunities. In this case redistributive policies may be implemented. DBs can provide

finance for investments in sectors or regions which would otherwise be neglected.

(Multiple) market failures: Structurally weak regions such as rural areas in developing

countries are often plagued by multiple (i.e. credit, insurance and land) market failures and

high transaction costs due to their remoteness. As a result people often do not invest

sufficiently in new technologies and production inputs. Hence, agricultural productivity is

extremely low, while rates of poverty and vulnerability are high. DBs can facilitate regional

development by funding (rural) infrastructure (roads, market buildings, decentralized energy

supply, etc.) or financially incentivizing particular activities or behavior (e.g. extension

services, improved seeds, value chains or access to rural finance). Regional, bi- and

multilateral DBs tend to use grants or, in the case of income generating activities,

concessional loans in this context.

d. Financial Sector Development and Financial Inclusion

A capable and stable financial system is a “conditio sine qua non” for the development and smooth

functioning of market economies. Sustainable economic structures require that enterprises and

households have the possibility to save, borrow, insure themselves and perform financial transactions

at affordable prices. This is crucial for private investment, accumulating wealth, generating income and

escaping poverty and vulnerability. The structural and very broad impact of financial sector

development potentially reduces the need for subsequent public intervention in other areas. Many

interpret financial inclusion not only as a means but even as an end of development because it

strengthens people’s ability to master their own fate. With their banking know-how DBs are particularly

well-suited to support governments in financial sector development.24

There are numerous reasons for publicly supporting the broadening and deepening of financial

markets:

Market failure arising from asymmetric information: The relation between the creditor and

the debtor is complicated by asymmetric information because the former knows less about the

investment to be financed (and the reliability of the borrower) than the latter. The ensuing

uncertainty may lead to credit rationing even if the project in question is financially viable and

workable.25

DBs can contribute to solving the issue of asymmetric information, for example, by

promoting credit bureaus which help to improve trust and knowledge between the creditor and

the debtor.

Market failure arising from moral hazard: The relation between the creditor and the

borrower is complicated by moral hazard.26

Receiving a credit may lead to more risky behavior

24 Already their mere presence in the financial sector may help to increase the general confidence in the banking system (especially in the context of poor institutional settings; IADB, 2005). 25 For a detailed discussion of market failures arising from asymmetric information, see Stiglitz (1994).The same argument applies to the relation between the insurer and the insured (how to price an insurance product adequately if the risk to be insured cannot be assessed properly?). 26 The argument in this paragraph is also applicable to insurance (products).

19

which the creditor cannot adequately price when designing the credit product. Consequently,

credit may be rationed even for good risks. DBs can refinance institutions which tackle moral

hazard by providing innovative credit products such as group credit. Respective refinancing

lines can be offered at favorable rates in local and foreign currencies. Also, DBs can use (and

pay) commercial banks for on-lending concessional loans and introducing innovative financial

products for the final customer (see section 4c). DBs usually complement their support with

the promotion of responsible finance standards and capacity building measures.27

Box 5 - Making capital accessible for micro, small and medium enterprises

KfW aims at strengthening inclusive, sustainable and resilient financial markets. As one of the

world's leading microfinance financiers it focuses especially on improving the access to

adequate financial services for the poor and financially excluded. The other key target group are

micro, small and medium enterprises (MSMEs).

For instance, in 1997 KfW (together with other donors) supported the establishment of a

microfinance bank in Georgia with EUR 2.56 million for equity, refinancing and capacity building.

One year later the Georgian bank reached its break-even point. It introduced new financial

products for MSMEs (financial broadening), but also offered savings accounts to the poor and

formerly unbanked (financial deepening). Soon thereafter three commercial Georgian banks

entered the domestic credit market for MSMEs. Increased competition led to more supply of

financial services for Georgian firms, as well as to lower interest rates. Nowadays, the bank

does not require public backing anymore and refinances itself exclusively via the private

financial market and domestic deposits.

KfW also supports (micro-)finance institutions indirectly by establishing (micro-)finance funds.

Many of these are structured in different risk-return layers which attract, among others, private

investors. The funds finance loans to be invested in the real economy. A prominent example is

the European Fund for Southeast Europe (EFSE) which was established at the end of 2005.

EFSE contributes to financial deepening and broadening by refinancing microfinance

institutions. These use the capital to provide MSMEs and households with loans. Thus, they

spur private sector development, employment and income. EFSE is divided into different risk-

return-layers encompassing four tranches - a junior (most risky), a mezzanine, a senior and a

super senior (least risky) tranche. At the end of 2013 the fund had disbursed a total of

EUR 843 million, 16% of which originated from KfW’s own sources invested in the mezzanine

(EUR 20 million) and senior tranches. In less risky tranches it crowded in private capital

(e.g. EUR 147 million in the super senior tranche).

Missing collateral (failing land markets): Moral hazard is less of an issue in case of credit if

collateral is available. However, this is often not the case in poorer sections (often rural areas)

of developing countries. The major source of collateral for many (farmers) in developing

countries is land. But failing land markets characterized by land titles which are not awarded in

the first place, not clearly defined or not enforceable do not offer this collateral. Hence, it is

often not possible to receive conventional credit products from formal private banks. Again,

DBs can support the offer of innovative financial products which substitute missing collateral

like group credit by refinancing respective financial intermediaries. Alternatively, they may

provide equity and mezzanine finance to broaden and deepen the scope of activities of

cooperating banks (see box 5 for KfW’s backing of a Georgian microfinance bank).28

27 The latter are aimed at handling new technologies, managing risk and liquidity professionally, etc. 28 The provision of private equity and mezzanine products via intermediaries to SMEs is also possible but only if the financial sector is well developed and stable.

20

High transaction costs: Demanding very small amounts of credit or insurance may cause

prohibitively high transaction costs in relation to the volume of the deal from the point of view

of private financial institutions. DBs can facilitate the introduction of new (credit) technologies

(e.g. microfinance, mobile money solutions) which allow to lower transaction costs

substantially.

Elevated medium- and long-term risk: Any difficulty to assess medium- to long-term risk

due to, for instance, political and economic uncertainties tends to constrain the private supply

of medium- and long-term finance. This issue exists in both underdeveloped and well-

developed financial markets and hampers in particular investment with long amortization

periods. In this case DBs can provide long-term finance or signal the financial viability of long-

term investments by acting as an anchor investor. Moreover, they may establish structured

funds in which the more risky layers are financed by public funds while private capital goes to

the less risky layers (see box 5 for an example from Southeast Europe). Guarantees are (by

their risk-covering character) another means to incite private financial institutions to expand

their lending activities.

e. Promoting Good Governance, Strong Institutions, Peace and Stability

Poor governance is often a key obstacle to sustainable development. Some observers regard poor

institutions as the main reason why nations fail (Acemoglu and Robinson, 2012). Civil conflicts and

wars tend to cause great human suffering and destroy within a short period of time the achievements

of many years of development in terms of physical infrastructure, social cohesion and mutual trust.

Many conflict-affected states do not manage to break the vicious cycle of poverty and violence

themselves. Hence, creating an enabling environment for doing business and private investment

comprises promoting good governance, strong institutions, as well as peace and stability (additionally

to economic and financial sector development). Typically many regional, bi- and multilateral DBs

engage in facilitating good governance and strong institutions, while this usually is beyond the scope

of national DBs.

Public intervention in institution and peace building, as well as governance issues addresses the

following developmental constraints:

Forgone revenues/high costs of bad governance and poor institutions: Bad governance

and poorly functioning institutions weaken the stability of the law, property rights, as well as

public administration, domestic resource mobilization and financial management. They go

hand in hand with corruption, increase the risks of investment (low predictability of future

developments) and delay economic transactions and administrative processes. All this

dampens private sector activity and consequently job creation, growth and public revenues.

DBs can strengthen governance and institutions by offering low-income countries grants and

lower middle-income or richer countries concessional loans to share the cost of implementing

reform programs (general or sectoral budget support).29

The respective financial support is

often accompanied by institution- and capacity-building measures.30

Low institutional capacity at lower levels of government: Although districts, municipalities

and other local authorities would be best placed to spur local development (close link to target

groups, political accountability), they often lack adequate administrative skills and appropriate

funding to build, maintain and operate public infrastructure and services. In such contexts,

29 Typical approaches employed in this context are sectoral and general budget support programs (e.g. implementing educational policy reforms), macroeconomic programs (aiming at, for example, trade liberalization and regional integration), policy-based loans and measures that target specific governance areas like public financial management (strengthening of tax administration and national audit offices, among others). 30 These focus on, for instance, the improvement of domestic resource mobilization, public financial management, political participation of civil society groups, the strengthening of anti-corruption agencies and the reduction of fiduciary risk (i.e. the risk that earmarked funds are not spent for the intended purpose).

21

DBs can fund capacity building measures and decentralization programs (e.g. setting up fiscal

transfer systems).

Short-run consequences of civil conflicts and wars: In war-torn countries the government

typically loses power and trust. Administrative functions are interrupted and basic social and

economic infrastructure is often negatively affected or completely destroyed. Those countries

typically run a high risk to stumble from one crisis into the next. A quick public response is vital

to escape this fragility trap, to reestablish trust in the state, and to revitalize private sector

activity. DBs can facilitate this response by financing necessary short-term interventions

aiming at, for instance, the reintegration of refugees and ex-combatants, food security,

emergency water supply, temporary housing, etc. (see box 6 regarding KfW’s support of the

Democratic Republic of Congo). Financial assistance to fragile and post-crisis states is usually

given as grant.

Medium- to long-run consequences of civil conflicts and wars: In order to assure a stable

development path short-run measures have to be combined with medium- to long-run

interventions. The latter further the trust in markets and the state necessary for investments

with long break-even periods and for private sector driven development. DBs can flank their

short-term measures with funds for long-term development (e.g. extension and rebuilding of

infrastructure including schools, health care centers, roads, housing, water and energy supply;

job and income generation programs; state-building).

Box 6 - Recurring tasks of reconstruction

KfW was initially founded in 1948 to finance the reconstruction of war-torn Germany after World

War II. This type of task continued to accompany the bank in one way or the other over time as

new challenges of reconstruction arose at home and abroad.

In 1989 the Berlin Wall fell, in 1990 Germany became reunited. In former Eastern Germany

decades of central planning and economic mismanagement left a very weak private sector, as

well as infrastructure and the housing stock in very poor condition. The ensuing comprehensive

overhaul, dubbed “Aufbau Ost” (Construction East), was a political top priority - and KfW was

heavily involved in it. By 2013 the bank had provided the eastern part of Germany with

promotional loans totaling some EUR 185 billion for supporting SMEs (EUR 100 billion),

improving housing fabric (64) and rehabilitating municipal infrastructure (21). This contributed to

an impressive economic upswing - between 1991 and 1997 Eastern German per capita gross

domestic product rose by more than 60% (excluding Berlin) - unmatched by any other

transitioning economy of Eastern Europe.1

Abroad KfW’s reconstruction efforts focus on fragile, post-conflict countries. A case in point is

the Democratic Republic of Congo which has been plagued by armed conflicts and violence

particularly in the East since decades. As a result there is hardly a basis for economic and social

development. Around 3 million people are on the run. Against this background speedy

assistance in multiple dimensions is fundamental including the rehabilitation of basic

infrastructure, refugee support, reintegration of ex-combatants, employment programs for the

youth etc. In cooperation with the Congolese Government KfW has set up a multisectoral

“Peace Fund” which had disbursed grants worth more than EUR 60 million to 66 individual

projects by the first quarter of 2015. Among others, it has financed the rebuilding of schools,

health care centers, rural roads, bridges and markets. For the labor-intensive construction works

many ex-combatants were employed which facilitated their reintegration into society.

1 Borger and Müller (2014)

22

f. Fostering financial stability by playing a countercyclical role

Last but not least, the need for acting countercyclically in times of recession or financial crises may

justify public intervention. The recent global financial crisis, for example, led to a crunch of private

credit with negative consequences for growth and employment in the real economy. This triggered

countercyclical public policy responses in many countries. Many DBs have played a widely

appreciated role in this context by stepping up their concessional lending operations when private

credit got scarce (World Bank, 2012).31

Using DBs to fill the cyclical gaps of private credit supply and foster financial stability is primarily based

on these arguments:

Insufficient private credit supply during a crisis: Economic downturns compromise hard-

won development gains, jobs and income. They may be cushioned via increased investment

which contributes to pushing economies out of recession. Therefore governments often resort

to expansionary monetary policy, lowering interest rates during a contraction. However, this

measure may not have the impact hoped for because it weakens the incentive of private

financial institutions to supply credit. Also, private banks may be unwilling to increase lending

if the soundness of their portfolios and future investments deteriorates during a crisis (which

may lead to a credit crunch). In the academic literature this rational for public lending becomes

manifest in the so-called “macroeconomic view” (IADB, 2005). DBs can moderate credit

supply by the countercyclical provision of loans. Domestically they may provide commercial

banks with so-called global loans which, for example, are earmarked to be passed on to SMEs

(with commercial banks possibly receiving a certain margin for the on-lending; see also

section 4c). Abroad they may lend to other DBs which use the funds for extending their

financing programs (see box 7 for KfW’s lending activities during the recent global financial

crisis). If low-income countries are struck by recession regional, bi- and multilateral DBs may

provide grants for public investments to facilitate economic recovery (either directly or in the

form of temporary budget support to allow expansionary fiscal policy).32

More prudential regulation in response to financial turmoil: In response to financial crises

toughened regulation may cause financial institutions to further curb their financing activities

which can widen the structural financing gaps particularly with respect to risky medium- to

long-term investment. Increased public lending may not merely be necessary during financial

turmoil but also in its aftermath when the supply with long-term private capital is more prudent.

DBs can fill the financing gaps without undermining toughened regulation.

General volatility of financial markets: Volatile financial markets entail risk and therefore

hamper investment even when not being in a state of crisis. Forward-looking structural action

(rules and regulations, etc.) is the most sensible approach to circumvent costs of both

macroeconomic uncertainty and (prevented) shocks. Offering long-term finance at fixed

interest rates, i.e. the core business of DBs, increases the predictability of growth trajectories

facilitating and stabilizing other investment. Moreover, promoting and adhering to principles of

responsible finance including rigorous, responsible and transparent lending policies

strengthens the resilience of domestic financial markets. If engaged in financial sector

development DBs can actively introduce and promote responsible finance practices.

31 However, whether DBs can effectively act countercyclically is disputed. It requires a very quick and flexible response to increase their lending operations if private banks reduce their activity. As soon as the private financial sector recovers, DBs may have to be equally quick and flexible in reducing their level of activity. This characteristic is coined “sleeping beauty syndrome” in the academic literature (Stephens, 1999, as cited in IADB, 2011): During periods of economic boom DBs can reduce promotional activities. Therefore, their respective expertise, i.e. their “beauty”, should be “put to sleep”. But when a crisis strikes they have to “wake up” immediately. Keeping promotional expertise and knowhow and continuously being perceived as a reliable partner in structuring and financing projects while not implementing promotional activities may pose a challenge to DBs. 32 In this context DBs may also use grants to support cash transfer programs to protect the poor.

23

Box 7 - Weathering the financial crisis of 2007/08

The global financial crisis of 2007/08 and its aftermath had a devastating effect on the global

economy which was in recession from 2008 to 2012. In 2009 Germany’s gross domestic product

shrunk by 4.7%. It was the most severe economic setback since 1932. In response Germany’s

Federal Government adopted two economic stimulus packages which were underpinned, among

others, by the so-called “KfW Special Programme”. The program was initiated in 2009 and

extended through 2010. It aimed at mitigating the impact of the crisis and quickly putting the

economy back on track. Among others, it disbursed promotional “Global Loans” to commercial

banks to refinance flexible and customized loans for SMEs. Commitments under the “KfW

Special Programme” reached EUR 13.3 billion by the end of 2010. Small enterprises with an

annual turnover of less than EUR 10 million constituted around two thirds of its target group. It is

estimated that these enterprises’ overall capital expenditure secured some 1.2 million jobs.

While Germany quickly recovered from the crisis, other European economies continued to

stumble. KfW stepped in to stabilize credit supply abroad. In 2013 it granted two concessional

loans totaling EUR 1 billion to the Spanish promotional bank Instituto de Crédito Oficial (ICO).

Following the same approach as KfW, ICO passed the funds as low-interest rate loans via

commercial banks on to SMEs which face crisis-induced financing and liquidity bottlenecks.

Similarly, in 2014 KfW supported Ireland’s promotional bank (Strategic Banking Corporation of

Ireland) and Italy’s promotional bank (Cassa Depositi e Prestiti) with global loans worth EUR 150

million and EUR 500 million, respectively.

4. Guiding principles of effective, efficient, and sustainable development banking

The actual design of a DB is very much dependent on circumstances: How are the national economy

and the national banking sector structured? Which market failures should be tackled? Which other

promotional or regulatory instruments are available (e.g. tax reduction, subsidies, allowances, laws)?

How do existing promotional laws look like? It is indispensable to consider the particular context.

Nonetheless, from our experience the following guiding principles regarding (a) the institutional setup

in terms of refinancing, (b) the organizational setup, (c) market conformity, and (d) conventional and

developmental banking standards should be adhered to in any context to facilitate the successful

performance of DBs (see table 5).33

Box 8 presents key features of KfW’s setup and operations.

Table 5 – Four guiding principles for successful development banking

Guiding Principle Key Components

a Generating financial resources autonomously

Explicit and direct statutory guarantee to allow for refinancing on (inter-)national financial markets at favorable terms

Concessional loans from regional, bi- or multilateral DBs

Profit retention

b

Designing the organizational setup to avoid crowding out of the private sector and political misuse

Precise mandate defining and delimiting the scope of promotional activities

Sound legal and regulatory foundations

Well-defined corporate governance structures delineating the roles of different stakeholders

c Acting market conform and competitively neutral

Principle of subsidiarity

Principle of on-lending (for highly standardized and low-risk promotional programs)

d

Applying conventional and developmental banking standards simultaneously

Conventional banking standards (e.g. professional risk management, internal and external audits)

Developmental banking standards (e.g. independent evaluation of development impact including lessons learnt)

33 The following discussion partly draws on De Luna-Martinez and Vicente (2012), IADB (2011), Rudolph (2009), and Scott (2007).

24

a. The institutional setup in terms of refinancing

DBs should be allowed to use different refinancing sources (see graph 1):34

Statutory guarantee and refinancing on (inter-)national financial markets (and direct

budget allocations; panel A): For DBs, the prime source of refinancing should be national

and international financial markets where the refinancing cost depends mainly on the credit

rating of the borrower. Provided the public owners of the DB have a favorable credit rating,

they can facilitate the refinancing of the DB by issuing a statutory guarantee for the institution.

This enables the DB to lend at similar rates as its owners, which is usually much better than

that of local private banks. Consequently, the DB can extend lowly concessional loans even

without tapping scarce public funds, simply by passing on the refinancing advantage to the

recipient. For higher concessional financing instruments, DBs rely on the provision of funds

from public budgets.35

Concessional loans (panel B): Not all DBs have owners which enjoy a high credit rating or

broad financial market access. In those cases DBs may seek refinancing lines from DBs with

a higher credit rating (see box 7 on how KfW lends to other European DBs). This approach

would not put a direct strain on the public budget either and similarly facilitate promotional

activities.

Profit retention (panel C): Regulations which prohibit dividend payments to the public owners

strengthen DBs’ independence and increase their own equity and thus their promotional and

risk-absorbing capacity.

Graph 1 – Financial setup of a State-Owned Development Bank (refinancing)

34 If DBs act as first-tier banks on their liability side they may also use savings and deposits from their customers to finance their promotional activities. 35 If the returns of DBs’ investments do not cover the associated transaction costs, the public owner has also to pay for the latter.

25

Box 8 - Insights into KfW’s setup and operations KfW’s shareholders are the Federal Government (owning 80 % of KfW’s share capital) and the German Federal States (20 %). Nowadays, KfW’s mandate includes the promotion of SMEs, infrastructure and the housing industry, protection of the environment and climate, Financial Cooperation with developing and emerging countries, etc. But the mandate was not always that holistic. Instead, it evolved over time and was continuously adapted to new development challenges. Since its foundation in 1948 the bank’s activities changed accordingly:

1

At first, KfW contributed significantly to the quick recovery of the German economy (later referred to as the German “Wirtschaftswunder”/economic miracle) by lending Marshall Plan funds to SMEs and for the rehabilitation and extension of buildings and infrastructure (particularly in the energy sector).

In the 1950s the continued financing of reconstruction mainly focused on housing and energy supply (particularly coal).

In the 1960s domestic promotion concentrated on SMEs. Internationally, KfW Group increasingly engaged in export financing and started to implement Germany’s Financial Cooperation with developing and emerging countries.

The 1970s were marked by two global oil crises why the financing of energy efficiency and saving emerged on the Group’s agenda. Also, the promotion of innovation became more and more important. The 1980s largely saw a continuation of previous efforts.

In the 1990s, after the fall of the Berlin Wall KfW Group was a key player in the reconstruction of Eastern Germany (“Aufbau Ost”). Its financing activities included the refurbishment of existing dwellings, the rehabilitation of municipal infrastructure and the support of nascent private SMEs. After the turn of the millennium the Group took over several other public banks, among them DEG, while it hived off the commercial banking business of export and project finance (IPEX). The bank’s mandate is defined in the institution-specific KfW Law which further provides the bank with a statutory guarantee for its liabilities and allows it to retain profits. The law also outlines the membership structure and the duties of the supervisory body. The latter is composed of representatives of the shareholders, as well as members of parliament including from opposition parties, representatives of federations, unions, associations of employers, etc. In 2013 it was augmented with a new article declaring central banking supervision applicable to the bank. Related regulations will become binding for KfW in several stages during the upcoming years. Moreover, KfW commits itself to principles of sound corporate governance including transparency. It complies with the recommendations of the Public Corporate Governance Code of the Federal Republic of Germany and discloses any potential deviations. Consolidated and annual financial statements, as well as the quarterly and semi-annual reports are posted on its website. KfW benefits from a statutory guarantee of Germany’s Federal Government which ensures an excellent (AAA

2) and sustainable credit rating. The bank refinances itself by issuing bonds on

international financial markets in different currencies (mainly in EUR and USD).3,4

In 2014 KfW issued bonds worth around EUR 58 billion. It is among the largest non-state issuers in the world.

KfW is a second-tier bank for domestic customers.

5 All German commercial banks are allowed to

on-lend promotional products of KfW and access them at the same (program specific) terms and conditions. KfW’s adherence to the principle of subsidiarity is illustrated, among others, by decreasing financial commitments for German SMEs since 2012 in light of an extensive supply with private capital (from EUR 24.1 billion in 2012, via 22.6 in 2013, to 19.9 in 2014; minus 17.4% within two years).

1 For a more detailed overview of KfW Group’s history see KfW (2015). 2 KfW has repeatedly been awarded the title of the world’s safest bank by “Global Finance” (last in 2014). 3 KfW’s EUR 1.5 billion five-year Green Bonds won “International Financing Review’s” Socially Responsible Investment Bond Award in 2014. 4 In some cases KfW also uses budget allocations from the Federal Government to further decrease interest rates of its promotional programs. 5 Domestic educational finance is an exception to this rule. Internationally, KfW lends through retail and wholesale operations.

26

Thus in terms of refinancing, there should not be a level playing field for private banks and DBs. The

latter need structural advantages to generate promotional capacities. This differentiation is less

problematic as it may seem at first sight: DBs should not compete with private banks anyway. Instead,

they should be constrained to complementary lending.

b. The organizational setup

With respect to the organizational setup of DBs mainly three aspects matter: (i) a precise mandate, (ii)

laws and regulations, and (iii) the corporate governance structure. All of them should be conducive to

two broad goals: No crowding out of the private banking sector and avoidance of political misuse.36

:

Precise mandate: The mandate of a DB should

o emanate from the identification of specific markets failures, undesired market

outcomes, externalities, etc. which the DB is supposed to address;

o be as precise as possible clearly delimiting the developmental purpose of the financial

institution;

o embrace the promotion of sustainable development as opposed to the maximization

of profits; and

o comprise the need of operating financially efficient and sustainable over time.

When formulating the mandate a tradeoff between narrow and broad instructions has to be

addressed: On the one hand, narrow mandates are preferable to broad ones because the

latter are more prone to political misuse, inefficiencies, hidden operating losses, and

competition with the private sector. On the other hand, narrow mandates can be costly as they

lack flexibility with respect to the use of promotional instruments. A “smart” mandate is precise

enough to avoid mission creep (i.e. it determines “what” to promote) and broad enough to

allow DBs to use the most efficient promotional instruments (i.e. it allows the DB to flexibly

determine “how” to promote).

Also, given that development challenges change over time, for instance from the eradication of

poverty to the reduction of inequality, any mandate should be reviewed on a regular basis to

assess its continuing validity.37

Certainly, such reviews run the risk of allowing undue political

interference. But only evolving mandates do not become outdated.

Laws and regulations: The mandate should be stipulated in a law (or a regulation; as should

be the corporate governance structure, statutory guarantees and other financial privileges) in

order to make it verifiable and enforceable. DBs should be corporate entities under corporate,

banking or institution-specific law. They should be subject to the same general regulations

which apply to private banks such as procurement, contract and labor laws, regulatory and

supervisory standards, as well as accounting, auditing, transparency and disclosure

requirements.

Corporate Governance: Corporate governance determines the roles of different stakeholders

and is vital for the performance of DBs. Adequate corporate governance structures should

o separate the responsibilities for exercising ownership of DBs, on the one hand, and

regulatory / supervisory functions, on the other, to avoid conflicts of interest; and

o clearly delineate the roles, responsibilities and authorities of the governance bodies of

36 Critics often caution about DBs being captured by politicians and government officials who pursue personal benefits rather than public interests. In the academic literature this opinion is expressed in the so-called political view (Krueger, 1974; Shleifer and Vishny, 1994). According to this view political misuse of DBs is a widespread phenomenon and provokes the inefficient allocation of scarce public funds. Although the political view is supported by several empirical analyses, one can also identify “bright spots among development banks (for example, Mexico’s NAFIN and Germany’s Kreditanstalt fuer Wiederaufbau [KfW])” (World Bank, 2012). For a more general overview of this discussion see World Bank (2012). For analyses of specific countries and DBs see, for instance, Carvalho (2010); Claessens, Feyen, and Laeven (2008); or Dinç (2005). Note that all of these studies establish significant correlations, but do not rigorously identify causalities. 37 Young DBs may prefer to concentrate on only a few key promotional tasks at the beginning. When they have accumulate experience and learned by lending they may review and expand their mandate.

27

DBs (owners, board of directors, executive management, etc.).

The supervisory body should represent the owners and a wide range of society and banking

expertise (including for example unions, parliamentarians, economic associations, private

banking associations), in order to conciliate different promotional interests of society. The

terms of the members of the supervisory body should be finite, staggered and, whenever

possible, not overlap with the political cycle. The supervisory body should not be allowed to

interfere with the day-to-day business of the DB.

DBs’ executive management should be comprised of members with relevant banking

competence and experience. It has to be granted operational independence, implying the right

to refuse promotional activities which endanger the capacity of the DB to sustainably fulfill its

mandate (particularly with respect to cost-coverage, pricing, liquidity, risk carrying capacity or

reputation) and to hire and dismiss staff. Executive managers’ appointment periods should not

overlap with the political cycle.

c. Assure Market conformity

An adequate organizational setup does not only support operational independence and professional

management. It also supports competitive neutrality of DBs, in the sense that it neither distorts

markets nor crowds out private lending. This market conformity can further be strengthened if DBs

commit themselves to two principles: (i) the principle of subsidiarity, as well as (ii) the on-lending-

principle (for highly standardized and low-risk promotional programs).38

Principle of subsidiarity: According to the principle of subsidiarity DBs should focus their

activities on fields not (yet) or not sufficiently served by the private sector (or served only at

unreasonably high prices which would endanger the expected developmental outcomes).

Examples range from the provision of credit in remote rural areas to investments in relatively

risky endeavors such as off-shore wind parks or in very costly and huge infrastructure

projects. In this context both the exact identification of financing gaps and the diligent tailoring

of promotional products are crucial because they ensure competitive neutrality and avoid

windfall gains for clients.

As outlined in section 2, DBs have financial instruments at their disposal which are well suited

to crowd in private investment. Whenever possible (and necessary because of the existence

of financing gaps), they should make use of these tools because unlocking private capital is

more subsidiary in character than financing entirely via promotional instruments. Irrespective

of the type of activity DBs are engaged in – promotional lending, unlocking private investment,

intervening in a countercyclical manner in financial markets during economic downturns,

pioneering the introduction of new financing instruments to demonstrate their financial viability,

etc. –, they should take special care to timely withdraw as soon as the private financial sector

is able to step in (again). Otherwise, the principle of subsidiarity may be violated although it

was adhered to in the first place.

Principle of on-lending (graph 2): Committing to the principle of on-lending also contributes

to the market conformity of DBs. On-lending DBs act as second-tier banks. In other words,

they channel promotional loans through retail, i.e. first-tier, banks avoiding direct competition

with the latter.39

Using the existing financial infrastructure of retail banks also allows to

minimize transaction cost: Rather than establishing a network of own branches, DBs can

employ the specialized local knowledge and existing client relations of retail banks. On-lending

38 The on-lending procedure is less suitable for larger and individually structured developmental interventions (e.g. large infrastructure projects) and higher risks. 39 An advancement of on-lending arrangements are so-called “global loans”. Rather than on-lending and administering each promotional loan separately, DBs provide a global loan to retail banks which have a sufficiently high promotional loan portfolio. The global loan agreement specifies the purpose, selection criteria and conditions which retail banks have to apply when using global loan funds. The lending decision is transferred from the DB to the retail bank. The DB only monitors the correct application of the agreed rules.

28

arrangements are therefore particularly useful for “bulk” promotional programs (large number

of credits with relatively small lending volumes), which are characterized by simple selection

criteria, highly standardized lending terms and procedures and relatively low risk.

Retail banks benefit from this cooperation in multiple ways: DBs compensate them for the

costs associated with on-lending. Moreover, they generate additional lending volume, get

access to long-term investment finance and develop related financial know-how. The following

features characterize a conducive on-lending mechanism:

o To ensure competitive neutrality and promote rather than bias constructive

competition among private financial institutions the on-lending of DBs should be non-

selective. That is, the latter should offer their promotional products at the same terms

to all capable retail banks.

o By requiring the financial intermediaries to bear some or the entire risk of the

investment and possbily to co-finance it, DBs can minimize the risk that bad debitors

are systematically transferred to them. Furthermore, such an approach ensures a high

degree of efficiency because it takes advantage of the strong self-interest in selecting

profitable projects and the well-informed risk assessments of retail banks.

o However, screening by first-tier banks which aim at maximizing their profits may

compromise the actual objective of promotional activities. For example, financing

startups via on-lent capital may be little attractive for private financial institutions

because of relatively small volumes and high risks involved. Therefore, special care in

tailoring on-lending arrangements is necessary. They should be cost and risk covering

for retail banks while creating sufficient incentives to not lose track of the

developmental goal. The promotional element intended to stimulate the closing of

financing gaps must not be absorbed by the financial intermediary. DBs should be

able to audit the on-lending behavior of first-tier banks.

o The on-lending margin for retail banks is likewise important. Costs and risks differ

between investment projects. Hence, not only lending conditions should be

determined case-specific but also, if possible, the on-lending-margin. A fix margin may

create relatively little incentives for retail banks to on-lend promotional loans to high-

risk and/or -cost clients even if the latter should be targeted from a developmental

point of view. Instead, a risk- and cost-adjusted compensation has more potential to

provoke well-targeted promotional lending. Obviously, flexible compensation

payments require comparatively advanced financial markets with limited information

asymmetries, as well as adequate rating and pricing tools.

Graph 2 – Financial setup of a State-Owned Development Bank (on-lending)

1

1The principle of on-lending is mainly relevant for national DBs acting in relatively well developed

financial markets.

29

d. Apply conventional and developmental banking standards

The fourth guiding principle for development banking operations is the compliance with (i)

conventional and (ii) developmental banking standards.

Conventional banking standards: Applying sound business practices facilitates financial

sustainability. Relevant standards comprise:

o prudent lending criteria;

o efficient use of available resources (incentivized for instance via a performance-based

salary component);

o professional risk management and pricing of promotional products;

o professional liquidity planning;

o internal and external audits; and

o a lean organizational structure.

Applying the standards does not mean that DBs should act exactly the same way as

commercial banks do (see “Developmental banking standards” below). It only implies that they

should act in a way which assures their financial sustainability.

Furthermore, management and staff of DBs should be motivated, well-qualified and have

banking experience. This implies paying competitive but not pacesetting salaries related to

performance.

Developmental banking standards: Development banking is more than banking. For

example, albeit having a professional risk management system, DBs must often assume more

risks than private banks in order to fulfill their promotional task. Too risk averse lending can be

counteracted, among others, by a clear mandate, regular disclosure of promotional activities,

and systematic independent evaluations of the development impact of DBs. Respective

lessons learnt should be used to improve the design and quality of subsequent promotional

programs.

Being less profitable than private financial institutions is not a valid argument against the

usefulness of DBs, as DBs are supposed to maximize social welfare rather than profits In

order to perform their task they need a much broader perspective of “success” based on a

profound understanding of development processes including economic, political, social and

cultural dimensions:

o The aim of promoting sustainable development requires that DBs apply economic,

environmental and social criteria in a holistic manner when tailoring promotional

products. In other words, rather than focusing on one dimension DBs should aim at

achieving simultaneous progress in all three of them. If this is not possible, existing

tradeoffs should explicitly be addressed.

o Tackling causes of underdevelopment tends to be more difficult than tackling its

symptoms. But DBs should resist the temptation to concentrate on the cure of

symptoms. They should finance structural rather than isolated solutions even if the

latter are more easily and quickly achievable and visible.

o A further important ingredient of the promotion of structural change is thinking in

“processes” and “context specifics”. Certainly, hardware is indispensable in this

context. But it only triggers sustainable development if it is smoothly integrated in

functioning local processes, regulations, institutions and behavioral patterns (supply

chains, staff training, maintenance, cultural beliefs, etc.). Unlike private financial

institutions DBs carry a particular responsibility to address this integration explicitly.

30

5. Summary and conclusion

DBs are important facilitators of national and international development. They have proven to be

capable of efficiently fulfilling various tasks of public policy if properly managed. These tasks have

become ever more complex over time and comprise propelling structural change – in terms of

economic, ecological, social and regional development –, promoting financial sector development,

fostering good governance, stability and peace, as well as mitigating macroeconomic shocks by

providing countercyclical finance. DBs meet their responsibilities with different instruments ranging

from tailor-made long-term finance via diverse forms of mobilizing private funds to expert advice and

technical assistance.

Governments are responsible for pursuing the rule of law and creating an enabling environment which

renders the room for legitimate direct public intervention as small and definable as possible. They also

have to carefully ponder alternative types of intervention such as regulations, subsidies, taxes and

allowances. Hence, DBs should mind their limits. Only if they are part of a well-designed policy

package, they can unfold their full development potential. If not appropriately managed they may be

politically abused and fail to resist a tendency for steady expansion. If their interventions are not

properly calibrated they may crowd out the private sector and/or produce windfall gains.

But DBs have the potential to be efficient and sustainable tools of public policy. Although the individual

recipes for success are very much context specific, there are some guiding principles whose

application helps DBs to live up to expectations: If a statutory guarantee enables them to favorably

refinance their promotional lending at (inter-)national financial markets they can generate promotional

effects even without tapping scare public funds. Profit retention is another important means to facilitate

their operations. A precise mandate, sound legal and regulatory foundations and well-defined

corporate governance structures contribute to political independence and a steady focus on

predefined core tasks. Adhering to the principles of subsidiarity and on-lending, i.e. acting as a

second-tier bank, supports the market conformity and competitive neutrality of DBs. Exploiting the full

range of financial and non-financial products allows them to crowd in private capital without generating

windfall gains.

Development banking is more than banking. It is about a profound understanding of development

processes including political, social and cultural issues and integrating economic, environmental and

social dimensions in each project. Properly designed and managed DBs can be a key tool to deliver

public policy in the decades to come and to finance the enormous investments required to achieve the

Sustainable Development Goals.

31

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