It's been almost two years since the expert panel review presented their review of multilateral development banks (multilateral lending institutions or MLIs in S&P Global Ratings' terminology) capital adequacy frameworks. A handful of MLIs have been actively exploring and responding to these recommendations, which we believe will over time reshape the sector.

Hybrid Notes Can Bring Improvements To Capital Positions

The African Development Bank (AfDB) issued hybrid capital notes for US$750 million to various commercial investors in January 2024. The World Bank also issued a hybrid instrument purchased by member governments this year. We expect other MLIs to follow suit over the next 24 months. Depending on the size of the instrument relative to the capital base, we expect that one hybrid issuance around this volume will bolster capital positions--by an estimated 50 basis points (bps) to 300 bps improvements to risk-adjusted capital (RAC) ratios. We don't expect hybrids to crowd out MLIs' traditional funding structures or replace general capital increases because this could, in our opinion, dilute the relationship with shareholders and hurt the enterprise risk profiles of MLIs. Instead, these instruments will be used as a complement to enhance capital positions.

Shareholders Can Use SDRs To Purchase MLI Hybrids, But Overall Volumes Will Be Contained

The IMF in April 2024 approved the use of special drawing rights (SDRs) in the acquisition of MLI hybrid instruments. We believe that this could increase the attractiveness of supporting MLI balance sheets through the purchase of hybrid instruments given that a sovereign member would not need to commit or use fiscal resources and would still potentially maintain its reserve asset status on these claims. We believe that SDR channeling for MLI hybrids has an attractive value proposition, allowing countries with larger SDR holdings to support lower income countries--similar to the Resilience and Sustainability Trust and the Poverty Reduction and Growth Trust funds managed by the IMF. We don't expect significant take up of these instruments in SDRs, given the use of SDRs to acquire hybrid instruments is subject to a cumulative limit of SDR15 billion; as well as potential complexities of approving hybrid instruments through national parliaments, and EU rules that prohibit EU sovereign members from purchasing hybrids.

Guarantee Instruments Are On The Rise

The sector has also been quick to expand the use of innovative instruments, particularly guarantee instruments--used for risk transfer and capital optimizations purposes as well as supporting mobilization efforts. Many MLIs have already used insurance schemes and guarantees as a risk management tool particularly to offload risk on specific assets on the balance sheet. We expect these types of schemes to intensify.

Already, some MLIs are using guarantees from highly rated sovereigns or other development agencies to offload sovereign risk, and various MLIs are exploring first-loss guarantees applied at the portfolio level. At the same time, many MLIs are exploring how to use guarantees to augment mobilization efforts on projects. The World Bank, for instance, has taken the lead--expecting to triple its annual guarantee issuance to US$20 billion by 2030, supported by reforms to this business line via an integrated guarantee platform which will be housed by the World Bank's Multilateral Investment Guarantee Agency (MIGA).

MLIs Are Expanding Their Policy Toolkit To Support Borrowing Members

We are seeing MLIs push the envelope beyond the traditional loan, grants, and guarantee instruments to enhance support to their members. This includes incorporating climate clauses into regular lending products, exploring climate insurance, and expanding local currency solutions, as well as providing hedging options to members. In the context of mobilization, and particularly given average low mobilization rates in low-income countries (see "Shareholders Are Calling On Multilateral Lending Institutions To Increase Private-Sector Capital Mobilization For Climate And Development," May 28, 2024), many MLIs are considering expanding the use of first-loss instruments and guarantee schemes that can incentivize private-sector actors into less-developed markets. We believe the take-up of these new instruments will be gradual but could over time fundamentally shift MLI business approaches.

While this may be in line with shareholders' objective to use MLIs as more effective developmental agents and underpin a stronger policy importance, we would also balance this with potentially more aggressive risk tolerance or material movements into new product lines outside the traditional area of expertise, which may represent more risk on the balance sheet, unless appropriately managed.

MLIs Are Exploring How To Better Utilize Callable Capital

In May 2024, various MLIs published reports on their callable capital--shedding additional insight into the mechanics, processes, and likelihood of resorting to a call on callable capital. While we believe this exercise speaks to the value of callable capital, we don't see these reports as representing a different view from our assumptions on the value of callable capital and shareholders' willingness to support a capital call.

We do expect the sector to continue exploring how this instrument can evolve over time to support MLIs' balance sheets in more meaningful ways, although we don't expect to see drastic changes to the fundamental nature of callable capital in the short term. Any changes to existing callable capital structures, in our view, may be very difficult to introduce given that these instruments are embedded into the Articles of Agreement. However, we may begin to see new instruments that are inspired by callable capital but are expanded in terms of usability and broader applicability on MLI balance sheets.

RAC Ratios Overall Remain Stable

The RAC ratios for the sector are extremely strong, on average--at 36% with December 2023 data and rating parameters as of June 21, 2024, compared to 35% a year prior--reflecting certain institutions' extremely high capitalization levels and low leverage. There have been some notable improvements in capital ratios for a variety of reasons: the International Finance Corp. because of its increased capital base and reduced equity investments; Black Sea Trade and Development Bank consolidated its loan book and continued its divestments of the Russian portfolio translating in a reduction to its risk-weighted exposure; we adjusted our view of the Caribbean Development Bank's preferred creditor treatment assessment based on its 10-year history; and the OPEC Fund For International Development's improved the risk profile of its assets. This was offset by other institutions expanding their developmental reach, which outpaced the growth in equity.

We expect capital positions to remain resilient supported by ongoing capital increases among many MLIs, combined with ongoing efforts to optimize the balance sheet. We believe this resilience in capital will buttress the sector's ability to expand its lending footprint or engage in riskier lending activities to better serve its clients, without all else equal, translating into rating pressures.