Development Finance Institution - DFIs and Risk

DFIs and Risk

DFIs' mandate requires them to invest in areas commercial banks do not, towards poorer countries and sectors and as hence they face higher risks. DFIs must help markets grow and seek to improve the investment climate, in order to demonstrate that enterprises can develop in economically challenging markets, thus contributing to sustainable development. However, since private capital must also be involved and their continued investment in future projects ensured, a commercial return must be achieved. Yet DFIs seek to resolve these two conflicting factor through an 'optimum' level of risk by balancing the cost of managing elevated levels of risk (e.g. loss provisions on loans, guarantees and equity impairment revaluations etc.), with the need to maintain liquidity sufficient to ensure strong institutional credit ratings, a low cost of borrowing, and generate a surplus to support technical assistance and grants.

Experience might suggest DFIs have operated at an optimum, for instance, during the Asian financial crisis of the late 1990s, portfolios were riskier, loan losses higher and returns lower than they are at present, but it did not adversely affect their institutional credit ratings due to state backing. The EBRD argued it was able to weather the impact of a major shock 3.5 times the size of the global financial crisis triggered by the Asian financial crisis, using only accumulated reserves.

However, it does appear that DFIs were lowering their expose to risk during the period leading up to the 2008 global financial crisis, capital adequacy ratios were increasing, bad loan reserves decreasing and portfolio shares in Africa were unstable. The IFC's loan loss reserves fell from 21.9% of the total loan portfolio in 2002 to 8.3% in 2006, and EBRD’s from 12% in 1999 to 2% currently. The share of sub-Saharan Africa in IFC’s portfolio was only 10.7% in both 2001 and 2007. Policies seeking to buck this trend involved changing staff remuneration policies. For example, the IFC introduced a remuneration process that links salary awards not only to volume but also to the development impact of past investments. This could lead to greater financial risk, but greater development effectiveness. Research by the FMO suggests that projects with a high development impact produce higher rates of return. The DEG rewards projects with good development ratings.