By Ian Callaghan – Published on ndci.global on 4 September 2017
NK: It’s for people who are aware of DFIs in some way, but perhaps not all that clear on what they do or how they think. So, people in the mainstream finance sectors, policymakers, people in NGOs and so on. It’s being distributed quite a bit at conferences too. I’m finding that I’m getting the most feedback from younger readers, and that’s good because the starting message of the book is that we need to make these changes to create a more sustainable world very urgently, and they get that.
You were at FMO for nearly 30 years. What would you say was the main change during that time?
At the outset, just financing investments in emerging markets was different and a challenge. Everything you did was in that sense ‘additional’. Finding good entrepreneurs was everything (not that this has got any less important). Now FMO, and indeed the development finance world as a whole, is much more focussed on development impact and governance. Measuring social and environmental impacts is now key, and for FMO that was centred on measuring jobs and the quality of jobs – for example, in respecting human rights – and climate change effects.
The great thing is that entrepreneurs themselves are now leading on these issues. Governments have been slower on the uptake – there’s still quite a lot of suspicion that you can’t make profits and do good at the same time. But I think that perspective is changing – I saw a breakthrough in Addis Ababa, in the accord on financing the SDGs. Governments are seeing their own limitations in terms of funding projects and creating jobs, and recognising the importance of private sector investment.
I was fascinated by one change you mention at FMO, which was to transfer the staff who were experts in environmental and social risk out of the risk department and into the commercial teams. What was the reasoning behind that?
Traditionally, analysing these risks was seen as something you did to protect yourself from reputational risk – people saying “why is FMO financing non-organic farmers” or whatever. And the analysis always came right at the end of the project, as a kind of final check, so it was seen by the investment officers as just a drag on their work.
Our staff learned to think alongside the entrepreneurs, not impose on them
But if this is your focus – just avoiding downside risk – you don’t spot the opportunities that these risks can often also present. When we changed our practice and housed the risk experts with the investment teams, because they were involved right the way through projects, they were able to point out how value could be added by addressing social, environmental and governance issues. To take a very obvious example, if your workforce doesn’t have to endure pollution in the workplace, they will likely be healthier and more productive.
As we had these pro-active conversations with potential investees, the entrepreneurs themselves started to see that taking steps to avoid ESG risks usually led to better business outcomes. Meantime, our staff learned to think alongside the entrepreneurs, they weren’t just coming up with lists of conditions at the end of a project, apparently just for the sake of it. They helped to develop action plans to address the risks, and these made achieving the conditions very concrete for the entrepreneurs.
We also found that taking this approach changed our own behaviour for the better. You can’t just be telling other people what to do because you have some money they want, you have to walk the walk with them and show that you are capable of acting in the same way as you are asking them to act.
With banks that we funded, where we also insisted that they institute good ESG compliance checks when they lent the money on, I found that it was important to get buy-in at the CEO level. It was at first surprising to them that when we met I wasn’t all that interested in their financial performance – I majored much more on how they were doing on this ESG front. That really brought the message home to them.
I was struck by the fact that FMO’s central target for its own profitability has been 6%. That figure reminded me that when I was involved in the financing the Channel Tunnel, which has a 100-year concession, we commissioned research on what the expectation should be for long-term returns on equity. The researchers were able to find company records going back to the formation of the London Stock Exchange in the 1660s, and the answer, over more than 300 years, was 6%. How did you arrive at your target?
No real magic there! FMO is owned by the Dutch government so it was a pretty simple equation of the Dutch sovereign rate plus a 3-4 % risk premium, which seemed a reasonable for a government to look for when taking these development risks. But the profitability point is an important one. Development banks need to be profitable, or they will be seen as just “philanthropy”. In the pre-crash period, commercial banks were aiming for profits in the mid- to high-teens percent, and there was an implicit suggestion that we as development bankers weren’t being as successful as them in that respect. But that kind of rate isn’t sustainable, as we discovered when the crash came along.
Do you think DFIs are taking enough risk, though?
Some of them, like the IFC and EFSE, have grown at 8-10% a year, and have big balance sheets now, so we can’t afford for them to fail because they take too much risk. In my view, the DFIs remain highly additive, not least because because they have been setting standards in terms of ESG and also in the standards for infrastructure projects. They are also consistently “there” as financiers in emerging markets – they don’t disappear when the going gets tough, as purely commercial players often do.
We are starting to see some movement on the risk front, though. The EU’s European Investment Plan (the so-called Juncker Plan) is setting some more ambitious leverage targets, and the World Bank has established a $2.5 billion high-risk “wallet”. Such money could go a long way in terms of funding first loss positions in blended finance structures, for example. But for startups and so on, DFIs need to do this through specialist fund managers, they don’t have the skillsets themselves. There’s is a lack of implementation capacity and projects in this early-stage area, but DFIs can help to create pipeline for others to then invest in.
You talk in the book about the FMO Investment Management project (FIM), where you set out to create funds that large mainstream investors such as pension funds could participate in, so as to build scale. That doesn’t seem to have moved very far – can you explain why?
FIM hasn’t worked out at the scale and speed we expected, that’s true. Pension funds in particular are very focussed on regulation and worried about reputational risk if they make losses, for obvious reasons given people rely on the income they get from them. I do think also, though, that they create boxes for themselves, like this or that strategy they want to pursue, and then investments don’t fit these sometimes arbitrary boxes.
I think we made some breakthroughs at Board level, but those aren’t translating down to management level, where the worries about losses and regulation and so on emerge. We need to create some kind of convening or framework where we can co-create. If pension funds could allocate say 5-10 percent of their capital to the SDGs, then governments could find ways of de-risking these funds and DFIs or green investment or other national development banks could be responsible for managing them, probably through blended finance. There should be something like the Business Commission for the SDGs, but for financiers.
You talk in the book about FMO being successful at investing in emerging markets because it has developed the right skillsets. As we’ve already seen, higher levels of profit than the 6% FMO is already generating are probably not sustainable long-term, so why don’t more mainstream banks or other financial actors accept that they can make a decent long-term profit in these emerging markets and develop the same skillsets as the development banks?
There used to be quite an active commercial banking network in places like Central America up till the 1990s, and they were quite focussed on SME finance. Unfortunately many of these banks then got subsumed into global banks, which are highly centralised and were really just interested in doing business with large corporates. Many have now been sold off again, as the international banks have pulled out of what they see as non-core countries, and they have meantime lost the skills they once had in things like SME lending, which is more risky and costs more to do, as you have to have the staffing to assess the entrepreneur properly. Regulation has also grown more complex and makes it more difficult to operate in many places. That said, as competition in banking markets grows, and it becomes less easy for banks just to make money trading government paper, they will start to look again at business like SMEs.
How can currency risk be addressed?
Currency risk is indeed neglected too much by development banks. Too much is being financed in hard currency, which pushes risks onto the borrowers. DFIs should be pushed to finance much more in local currencies. We have demonstrated through a company we helped create called TCX that currency risk can be overcome if you have a diverse enough portfolio – even in the circumstances of a major global crash, which came along soon after TCX was set up. One way to help would be to increase the capital of TCX, but there are others ways of covering currency risks than are commonly used today. We also need to involve local markets in financings much more, especially those that can provide long-term funding.