THE MULTILATERAL DEVELOPMENT BANKS
AND THE CAPITAL MARKETS
Robert M. Bestani
It is hard to convey to people who did not witness it, the extraordinary position that the major US commercial banks played in the early 1970s. As providers of both short and long term funds to the major corporations of the world they were absolutely central to international business. Venerable commercial banking names like JPMorgan, Chase Manhattan, Bank of America, Bankers Trust, Manufacturers Hanover, Continental Bank and others were monuments to international financial power and global reach. These institutions and others were enormous, monolithic, expansionary, international, proud and unassailable. They were “The Establishment.”
And then the currents of history shifted and they quickly disappeared - like so much dust in the wind. For decades they were essential to the markets as providers of funds. But, in the 1970s large corporations began to go directly to the financial markets; first to the short term markets through commercial paper and then to the capital markets for longer term monies. Price was the major driver. By cutting out the middle man they were able to significantly lower their cost of capital. But at the same time, there were able to eliminate the onerous covenants that the commercial banks imposed on them. The capital markets were seen as not only cheaper, but much faster, more innovative and efficient then the legions of commercial bankers that paraded through their front doors.
Along with a cheaper cost of debt, the investment banks brought with them a new arsenal of innovative financial engineering tools. Derivatives, private placements, zero coupon bonds, mezzanine financing, high yield bonds, securitization, advisory services, and other financial products brought new life and vitality to the financial markets. The commercial banks were overwhelmed and could barely keep up. They had few natural advantages to counter with.
In the end, the commercial banks had no choice but to evolve. Those who could make the transition survived. Those that could not, perished and were absorbed by the more nimble. In many cases, only the names survive – the last remnant of the former power and glory that once was. The venerable old names survived as the newer banks bought out the old and kept the former identities as cloaks of respectability. To a degree, the same was true in Britain and in Japan where there has been a dramatic contraction in the banking industry. Indeed, contraction is still the chief characteristic of banking worldwide.
In the last two decades there has been a fundamental shift in the markets. Clearly, the day in which a direct lending activity was needed has passed. This is as true for individual countries as it is the larger borrowers in the commercial sphere. All but the very poorest countries can now go directly to the markets for funding.
The same competitive pressures that faced the large commercial banks are now facing the multilateral development banks. All of the MDBs are feeling this although quite obviously they have yet to recognize the problem. The World Bank’s lending volume in 2004, for example, looks to be a third less than the volume they extended in 1999, falling from $29 billion down to $20 billion in 2004 even though they have lowered their fees and margins. For the first time, the World Bank’s grants and concessionary lending (IDA funds) is also below the so called market based lending (IBRD funds) – which in truth also carry substantial subsidy pricing.
To varying degrees, the same pattern holds true for the entire community of development institutions. In virtually every case, the level of lending from these institutions has dropped dramatically. Countries are either already borrowed to the hilt, can borrow more easily and cheaply themselves (without the costly conditionality and delays of working through development institutions) or have learned the lessons of the last few financial crisis which underscored the dangers of excess leverage
This pattern of declining lending is also true for the ADB. With the exception of 1997, when the financial crisis hit Asia, the ADB’s lending levels and disbursements have been on a downward slide. Indeed, the only growth figures are the net resource transfers i.e., the funds being returned back to the donor countries.
With an accelerating pace, the global capital markets have grown very dramatically in both size and sophistication over the last thirty years. Unlike the situation that prevailed in the 1960s where there was a capital shortage, there is now a capital glut. Today there is a great deal of money which can be tapped for both debt and equity investments. Indeed, it is estimated that there is between $3 trillion and $5 trillion in surplus funds floating around Asia that are not being put to good use. There is far more liquidity in the system than immediate investment opportunities.
This is not to say that the demand for investment is down. Quite to the contrary. In the last few months there has been a renewed emphasis on infrastructure and it is now estimated that Asia alone will require between $250 billion and $300 billion a year for the next ten years just for infrastructure spending alone. Some estimates suggest that when one bears in mind the lessons of East Europe this figure is a gross understatement. Where are these funds coming from? Obviously, a substantial amount will come form the capital markets. Indeed, the funds coming from the capital markets will dwarf the much smaller amounts that the MDBs can provide.
The multilateral development banks are now facing the same challenge as the large international banks confronted. Established in the post war period, the MDBs were formed to help the emerging countries of the world obtain capital. The World Bank and most of its sister institutions were founded on the need to borrow from the developed world’s money centers and lend to the emerging countries. When the Asian Development Bank was established in 1966 such an entity was vital; a lending institution was the only way to obtain the required funds for their development. In 1966 when the ADB was founded there was a 30% funding gap between what was available and what was needed.[1] The ADB was charged with finding those funds and making them available to the developing countries across Asia.
In a very real sense, the MDBs are now being “disintermediated” or squeezed out of the markets, just as a long list of major commercial banks were, taking with them their once famous institutional names. History does repeat itself: Unfortunately, the MDBs are in the same state of denial as the commercial banks were. In response to the lowered lending demand, the MDBs are all seeking to streamline their processes to cut costs and be more efficient. They are also cutting their lending rates to move more money out the door, just as the commercial banks tried to do.
To a former corporate banker this is deja vue all over again. It is altogether understandable that the MDBs seek to streamline down their operations and work to become more efficient. But, as the commercial banks discovered, this is a losing proposition as there is an immediate negative impact on earning from the lower fees and margins and they can never get their costs down low enough. Indeed, with their very heavy reliance on expatriate staffs, the MDBs have a much higher cost basis than the commercial banks ever did. In the end the situation is not sustainable. Something strategic must be done.
The client states are bluntly pointing this out to the MDBs. While their borrowing needs have changed, the borrowing countries have not seen a commensurate change in the MDBs. Just like the big commercial banks MDBs are still trying to push their lending services. But their loans are too expensive, slow and unimaginative. Very little has changed in the bank’s lending, whereas there has been a revolution in the financial technology of the capital markets. What the countries now need is help in accessing the capital markets. They are also saying what the commercial borrowers were saying to their commercial banks on matters beyond their immediate borrowing needs. Specifically, they are looking for new ideas, innovative approaches, perspective on the markets and technical advice.
Just as the major commercial banks have had to change, so to do the MDBs have to adjust to the new realities that face them. Through repayments and reduced borrowings, client states of the MDBs have been telling the banks that they don’t need them for their funds. The capital markets have changed the “direction” of the problem by 180 degrees. In a very real sense, we are still heading in the same direction we were in 1966.
The MDBs must all fundamentally change to reflect the revolutionary change in the financial markets. To date they have not done so. In the face of declining lending opportunities, the MDBs have been looking for new ways to remain relevant. A broad array of new undertakings and initiatives has emerged. The result has become “mission creep” to quote Jessica Einhorn.[2] Declining public sector project borrowing on a variety of state sponsored spending programs have spurred also balance of payment lending (with seldom adhered to conditionality clauses) to pick up the lending slack. Additionally, they have stepped up their grant programs and concessionary lending. While this as absorbed some of the underlying slack capacity, it has hardly been enough to fix the fundamental problem.
The danger is that the Banks are quickly losing their relevance, particularly to the larger states and the middle income countries. Both can more readily access funds on their own. Is this to say that the day of the MDBs is over? The answer is clearly no. The smaller weaker economies will always need the MDBs. But if they stick to lending as their reason for being they will, very quickly, find that they are small banks to the small countries. But just as the commercial banks learned, being a lender to a much smaller group of countries is hardly a strategic option. Their cost base is far too high for this to be a self sustaining option.
If the MDBs are to remain relevant to the middle income countries and even with the larger countries like India, China Indonesia etc., the MDBs need to effect a strategic shift in their operations. Just like the major commercial banks did, they must endeavor to take on functions that are much more akin to investment banks. That is to say that they must reduce their reliance on providing funds and dramatically seek to help the developing countries access funds from the capital markets.
Is this to say that the public sector lending is at an end? Hardly, but it will undoubtedly play a much diminished role in the future. But that lending will be confined to the smaller and less developed countries. The MDBs must begin to adjust and ask themselves how they keep their relevance to the larger developing countries like China, India, Indonesia etc., . In that sense, they should end up as universal banks that combine both lending activities and investment banking activities, depending on the need.
The Way Forward
Fortunately, in this capacity the MDBs have a unique advantage which the commercial banks never enjoyed. Between the demand for investment and the supply of funds, a critical element is missing. Its absence is suffocating the needed investment activity. In a word, it is confidence. Without confidence, the needed equity for new infrastructure investment is not, and will not be, accessible. Hand in hand with that equity investment, of course, goes the necessary technical and managerial expertise to actually get projects off the ground. Most of the large international companies that provided critically important leadership for infrastructure projects of all types have left the international scene. Their experiences in the region were almost universally bad, and the majority has retreated to their home countries to recover their financial health.
There are two key factors that explain the failure of so many international projects, particularly as related to the capital-intensive industries. The first is the lack of a solid and dependable regulatory framework in many sectors. Foreign firms have historically invested in the comparatively unregulated environment of emerging countries, hoping for the best. Again and again, however, they found themselves subject to the whims of host governments that failed to honor underlying contracts, or that felt free to change the regulations governing investments. After sinking into trouble one too many times, most players in the investment community have fled. They now are busy repairing the damage suffered to their corporate balance sheets. The mere mention of new international investments would be enough to send their investors rushing for the door, and their stocks into a tailspin.
The other reason major projects have suffered is that investors have been forced to invest using hard currencies in economies where there is no capital market to either provide long-term local currency loans or to allow investors to hedge foreign exchange exposures. The result has been financing mismatches that have seriously undermined, or in many cases destroyed, the economics of cross border investments. This is particularly true in the less developed countries. One of the most common characteristics of emerging economies is that their currencies are prone to weakness and their interest rate environments are highly volatile. Thus, even if local currency financing is available, it is only available on a very short-term basis, exposing investors to the risks of refinancing and interest rate volatility.
To manage these problems, the risk premiums that companies must charge to make a potential investment financially and economically viable are quite high. As a result, the tariff or charge that they must pass along to their customers is, accordingly, very high. For this reason, the likelihood of success for such investments is that much lower. Without investment activity and proper infrastructure spending, a country faces the near certainty of stagnation.