FINANCING DEVELOPMENT

Development Banking - Background

The term ‘development bank’ refers to a multilateral lending institution which provides funding to support economic development. Development banks have been known to fund a wide variety of ventures, including public health initiatives, infrastructure development, education programs, private business ventures, and good governance programs, to name a few.

The most prominent development bank today is the World Bank. There are four main regional development banks: the Inter-American Development Bank, the European Bank for Reconstruction and Development, the Asian Development Bank, and the African Development Bank. Additionally, many sub-regional development banks exist. As a general rule, development banks with smaller memberships tend to focus on fewer types of programs than development banks with larger memberships.

Development banks differ from private banks in a number of fundamental ways. First of all, member states rather than private actors serve as the ‘shareholders’ of development banks and representatives from the member states control each bank’s board. Moreover, development banks do not seek to maximize profits. Instead they typically have a mandate to promote economic or social development or to reduce poverty in their member states. But development banks are not simply sources of aid. Most assistance is given in the form of loans which must eventually be repaid.

Development banks are also distinctive because they tend to be staffed by experts in economics, finance, the law, and a range of other relevant fields and have years of experience funding development projects. As a result, they are able to provide considerable technical assistance during the planning and implementation of a project.

In recent years development banks have become increasingly concerned with the potential social and environmental impact of their projects. Thus, during the planning stage impact studies are often conducted to identify potential environmental and social risks. If it is determined that significant risks are present the bank will typically require an action plan that mitigates such risks before a project and proceed. Unfortunately many projects that have enormous poverty-reducing potential are laden with serious economic or social consequences. How banks negotiate these conflicts continues to be the subject of much debate (as will be seen by the following case study).

Development banks raise the vast majority of their funds by selling bonds to investors. Because the obligations of each bank to bondholders are backed by the assets of the bank and, to some extent, its member states, these bonds have excellent credit ratings. Their low cost of capital allows the banks to offer loans to member states at extremely favorable interest rates. Many loans also have unusually long payback periods, often extending up to 40 years.

Critiques of development banks

Despite their development-oriented mandates, development banks have often received harsh criticism from development experts and activists.

One set of concerns revolve around the conditions that development banks attach to their financing. These conditions are typically defended as means of ensuring that resources will be used as intended and programs help meet development objectives. The concerns are similar to those that have been raised about conditionality in IMF lending. They include complaints that: compliance with the monitoring and reporting requirements that accompany conditions is too costly; conditions fail to take into account the need to adapt development strategies to fit local circumstances; conditionality undermines the sovereignty of borrowing states and preclude the kind of local ownership of projects that is crucial to legitimacy and success; and the particular conditions that have been imposed are counter-productive. In response to these concerns in recent years most development banks have made consultation with member states a priority in recent years.

A second concern is that excessive lending from development banks has contributed to unsustainable debt loads amongst developing states. In principle a development bank should have no interest in making loans that undermine the economic development of its clients. However, individual agents within a bank may have professional incentives to make as many loans as possible. Promotions and prestige within a development bank are often tied to the number and size of loans for which a staffer is responsible. While ultimate approval is dependent on board authorization, individuals have an incentive to downplay the risks of a loan and overstate potential benefits when seeking board approval. These sorts of agency costs create a bias toward excessive lending.

The World Bank

Since the World Bank is the world’s preeminent development bank it is worthwhile to discuss its structure in greater detail.

The World Bank was created in 1944 during the Bretton Woods meetings. The bank has more member states than any other development bank, representing the vast majority of states in the world today. The Board of Governors has the ultimate decision making authority, and is composed of representatives from each of the member states. Nations with larger economies supply relatively large portions of the banks funding and are given voting rights that correspond to this. However, the Board of Governors convenes infrequently, and does much of its work during annual meetings. Day-to-day decisions are left to the Executive Directors. Five of the 24 Directors are appointed by the five largest shareholder states, with the remaining 19 Directors representing the rest of the member states. The Executive Directors meet multiple times weekly and have final authority over all loans made by the Bank.

The World Bank is actually composed of five units: the International Bank for Reconstruction and Development (IBRD), the International Development Association (IDA), the International Finance Corporation (IFC), the Multilateral Investment Guarantee Agency (MIGA), and the International Center for the Settlement of Investment Disputes (ICSID). As their names imply, ICSID is a forum for arbitration proceedings, and MIGA guarantees private investments to reduce the risk of financings in developing countries. The IFC provides loans to private entities that are pursuing projects in developing countries that will promote economic growth.

The IBRD and IDA are the two entities that most people actually associate with the World Bank. The two organizations share the same administrative staff and headquarters. The IBRD provides non-concessional loans and other financial services to middle-income countries (those with a per capita income of between around US$1,000 and US$10,000) and creditworthy low-income countries. The IDA provides interest-free loans and grants to the poorest countries in the world – generally those with per capita incomes of less than about US$1000 – which mostly do not qualify for IBRD financing. IBRD loans may only be given to member states, while IDA grants may be given to any state that meets its eligibility criteria. The IBRD makes lending decisions more or less on a case-by-case basis, whereas the IDA allocates funding using a complex Country Performance Rating (CPR) system designed to assess each country’s performance in implementing policies that promote economic growth and poverty reduction. Finally, the IDA relies on donor funding, while the IBRD is able to fund its operations through income from interest payments.

Special considerations applicable in post-conflict settings

Violent conflict inevitably leads to economic degradation and abject poverty. The World Bank, and the IDA in particular, often play a role in rebuilding efforts once the violence has subsided. A rapid development program is generally considered helpful as it is believed that extensive, persistent poverty increases the risk of political deterioration and a return to violence. However, financing development projects in a nation that has recently experienced serious conflict requires the consideration of a number of problems that are not associated with other development projects.

For example, the decision of whether to provide concessional financing to a post-conflict state probably ought to turn on different criteria from those used in states at peace. The IDA recognizes that the indicators that it usually uses to allocate resources, with its emphasis on demonstrated commitments to economic and legal reform are simply not appropriate for assessing the potential impact of aid in the extraordinary circumstances present in a post-conflict setting. Thus instead of its CPR it uses a special set of Post-Conflict Performance Indicators (PCPI).

The selection and design of projects to support in a post-conflict setting is also complicated. Post-conflict environments bring with them the risk of reversion to violence. The challenge is to begin reconstruction and development efforts in a timely manner but not so soon that investments are lost if violence resumes. There is also some risk that if handled incorrectly development bank activities could precipitate more conflict. For instance, a bank’s choice of local partners could exacerbate local tensions and the infusion of resources may provide targets for violence.

The destruction of physical and institutional infrastructure also makes it difficult to set priorities. It may make little sense to fund the construction of a power plant if electrical transmission lines have been destroyed throughout the country.

Donor coordination is also complicated in post-conflict settings. Because humanitarian disasters typically accompany an armed conflict, numerous aid agencies seek to provide relief once the violence has subsided. Development banks typically try to coordinate their own efforts with the work of various United Nations entities, the Red Cross, and other organizations. Effectively identifying which agencies should undertake which reconstruction tasks is challenging but important.