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p. 3 of 6 BACK | NEXT I. Introduction II. Regional Development and Strategic Context III. "Existing Instruments and Market Changes IV. Innovation and Pilot Concepts V. Implementation VI. Recommendation

Pilot Financing Instruments and Modalities

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III. Existing Instruments and Market Changes

A. Financing Instruments—Applications, Strengths, and Weaknesses

11. Over the years, ADB has developed a variety of instruments to finance stand-alone public and private sector projects, as well as broader sector and subsector investment programs. It also provides credit lines to financial intermediaries for onlending to private companies, normally small and medium enterprises (SME). With these instruments, ADB supports physical investments, as well as policy, sector, and thematic reforms. In addition, it provides technical assistance (TA) grants for project and program preparation and implementation, knowledge gathering, and knowledge sharing on various sectors and themes, including for capacity building, and regional cooperation and integration.

12. The main project finance instruments include debt, equity, and guarantees.⁸ Guarantees leverage ADB’s own financing to help mobilize cofinancing from external sources. These guarantees address political or credit risks, anchored in public or private sector loans. ADB also issues local currency bonds and, more recently, has tried to tap into cross-currency swaps to complement its traditional financing in foreign currency. All these facilities are variations on one theme—the provision of long-term debt or equity finance for development purposes. Quasi-equity and mezzanine financing also fall into this category, although ADB has not put together these types of transactions yet.

13. In this paper, “instrument” (or “product”) covers the generic means of providing or facilitating financing—debt (mostly loans), equity, guarantees, or grants. A transaction or investment “modality” involves the specific application of these products within defined legal, policy, and operational structures, such as: (i) program loans for sector adjustments; (ii) investment loans; (iii) bond issues and capital market transactions; (iv) swaps; (v) mezzanine financing; (vi) quasi-equity; (vii) public-private initiatives, such as financing and guarantee support for build-operate-transfer (BOT), concessions and joint ventures; (viii) political risk ‘carve-outs’; and (ix) financial risk-sharing partnerships. A modality may be covered under a specific policy paper (generally once it is mainstreamed) or through project specific applications (generally when it has a novel character). The pilot concepts covered in this paper deal with debt financing instruments which constitute the core of ADB’s operations, i.e., loans and guarantees, and related transaction modalities.⁹

14. The fundamental requirements for loans provided to clients from ordinary capital resources (OCR) and Asian Development Fund (ADF) resources¹⁰ are contained in (i) the Charter, (ii) loan regulations for ordinary operations and special operations, (iii) policy papers, and (iv) corresponding sections of the Operations Manual (OM).¹¹

15. In addition to regular project loans for investment lending, which account for the bulk of ADB’s project finance operations, ADB’s debt financing modalities comprise (i) program lending, and variations such as sector development programs and program cluster loans;¹² (ii) sector lending;¹³ (iii) financial intermediation lending;¹⁴ and (vi) emergency assistance lending.¹⁵ Additional policy papers and related sections in the OM regulate aspects such as security and guarantee arrangements for loans,¹⁶ guarantee operations to mobilize cofinancing¹⁷, financing eligibility criteria,¹⁸ and financial and risk management considerations.¹⁹

In addition, some provisions are specific to private sector operations.²⁰

16. Appendix 2 summarizes the main features of the key lending modalities, such as choice of currency, lending terms and fee structure, guarantee and security package, and documentation. While this list is not exhaustive, the purpose is to highlight areas where some adjustments are needed.

17. ADB’s financial modalities are both complex and simplistic. The numerous policies, guidelines and restrictions that limit their understanding by clients, ease of application, and adaptation to a changing business environment make them complex. But the financial modalities are also simplistic because, despite the elaborate policy framework and some built-in flexibility, most offer little differentiation with regard to key terms and conditions. Differences are primarily in terms of tenors and disbursement profiles.

18. Within this framework, the bulk of ADB’s business is stand-alone investment lending from concessional ADF or market-based OCR windows to public sector borrowers, backed by sovereign guarantees. Eligibility for financing depends on a set of development, income, and broad economic criteria of the borrowing country, which generally were defined long ago. Private sector finance involves debt, equity, or guarantees for cofinancing to private sector investors without sovereign counterguarantee, or a combination thereof, with debt extended normally on a limited or on a nonrecourse basis.²¹ Political and partial credit risk guarantees are used to encourage commercial cofinancing for public and private sector projects. However, these constitute a relatively small part of ADB’s total portfolio due to cumbersome procedures, lack of adequate incentive structures, and policy or charter restrictions.

19. ADB in the past has not financed local government entities or SOEs on a purely nonrecourse or limited recourse basis.²² However, this is routinely done by institutions such as the European Bank for Reconstruction and Development (EBRD), European Investment Bank, and Kreditanstalt für Wiederaufbau. Municipal governments and SOEs potentially constitute a “third generation” of clients, increasingly important as borrowers in their own right in most DMCs as a result of decentralization.²³ Refinancing, a standard feature in infrastructure and public services finance, has not been part of ADB’s regular business either.²⁴ Nor has ADB extended local currency financing to public sector clients.

20. Private sector operations also include arbitrary restrictions. ADB’s cost sharing limit is comparatively low at 25%.²⁵ The country and sponsor limits ($75 million per transaction) are misaligned with market practice and business opportunities. In addition, ADB policy does not support various forms of refinancing, securitization, transactions structured around capital and operating leases, and acquisition finance. Restrictions on guarantee operations also make it incompatible with market needs and practices and limit cofinancing opportunities. ADB can take greater advantage of financing opportunities (in both the public and private sector) without necessarily compromising its AAA rating and standard credit risk considerations which are built around the concept of sound banking principles, while maintaining a high development impact and project quality.

21. Notwithstanding the above, ADB debt instruments do offer a reasonable degree of currency and interest rate flexibility to clients, especially since the introduction of OCR lending based on the London inter-bank offered rate (LIBOR). This has given ADB and its clients much greater flexibility and market alignment than was the case with the fixed-rate currency basket system used in the past. It also has allowed ADB to broaden the scope, range, and flexibility of debt financing, through the incorporation of currency and interest rate swap options. Maturity periods and repayment schedules follow fairly standard formats. This allows, in principle, the use of more diverse structures, essentially to match the risk and cost recovery profile of individual investments with the principal and interest margin obligations. But despite this flexibility, some constraints remain, especially in terms of administration and financial management features. Borrowers are generally unable to calculate and accrue independently relevant loan charges. In addition, ADB cannot easily establish and maintain loan accounts at the sub-borrower level. The current progressive commitment fee structure exacerbates these problems.

22. Besides the interest margin over LIBOR, ADB normally charges clients front-end and commitment fees. In some instances, these charges can be waived temporarily (as is the case currently with the front-end fee). Also, public sector borrowers have consistently received the benefit of ADB’s sub-LIBOR borrowing costs through rebates. Commitment fees have always applied to undisbursed loan amounts. In addition to generating some income²⁶, the commitment fee is intended to instill ownership among clients and provide an incentive for speedier implementation of projects. However, commitment fees are charged on an upward sliding scale spread over the implementation period, assumed to be four years on average. Clients, who generally dislike these fees, feel that ownership of projects and commitment to efficient implementation plans are more a function of other considerations, such as (i) design aspects; (ii) disbursement schedules; (iii) executing agency capacities; (iv) working capital financing (budget allocations); and (v) ADB’s operational conditionalities, including those on procurement, safeguards, and administrative procedures. For large projects with long implementation periods, commitment fees act as a real disincentive. They also force ADB and its clients to focus on shorter-term slices of investment programs. Given the time required to process projects, this practice increases transaction costs and takes resources away from implementation tasks (and possibly from a more effective policy dialogue and implementation of governance and safeguard oversight). In addition, the contingent nature of the fee in lieu of disbursements makes the real cost of ADB’s loans less transparent than it should be. While other multilateral development banks (MDB) historically have charged these types of fees, some are considering abolishing them or applying flat fee structures. These banks intend to rely on other means to generate income, improve implementation efficiency, and enhance client commitment and ownership.

23. To raise funds in the market for subsequent onlending to clients at competitive rates, normally on a long-term basis, ADB relies on its AAA credit rating. ADB raises funds on fairly attractive terms because of (i) this rating, (ii) the nature and characteristics of its private placements, and (iii) the type and size of the bonds it issues. Lending conditions also compare favorably with those of other MDBs. The main problems are the nonfinancial costs of doing business, and the way in which instruments are used. Appendix 3 compares the terms provided by ADB with those of various MDBs.

B. Market Trends, Opportunities, and Challenges

24. Notwithstanding the financial terms of its current instruments, ADB’s appeal is diminishing in a number of markets. On the one hand, the rising nonfinancial (or hidden) costs, mainly driven by the plethora of policies and the increasing complexity of their application, has made ADB operations less attractive. On the other hand, a broader range of financing alternatives has emerged, especially in OCR countries, including national, regional, and international capital markets. Sustained high domestic savings and liquidity in the region have supported this trend. An increasing number of countries are willing and able to pay substantial premiums for speed and flexibility. They also have the option of working directly with export credit agencies. While these agencies might be more expensive and tie financing to the procurement of goods and services from their own country, they provide funds quickly and more flexibly. Other MDBs and bilateral financing partners are reviewing their instruments and modes of cooperation. Most are becoming more client-friendly. Taken together, this represents a major challenge for ADB.

25. ADB’s comparative advantage lies principally in the long maturity, grace periods, and attractive pricing of its financing; as well as in its potential to provide innovative and integrated solutions to development challenges (i.e., technical and other expert advice, and policy reforms). ADB also can provide ideas to mobilize other money with its own. This advantage is compatible with at least one of the core mandates of a development bank—to provide or help mobilize long-term financing for countries and projects that have difficulty raising such financing at reasonable terms and when needed. Even in countries with comparatively mature and liquid capital markets, as well as an active commercial debt sector, ADB can make a difference. By blending maturity and interest margins with other finance, ADB can improve financing terms of projects and programs without “crowding out” other partners. ADB can play a so-called catalytic, or value-added, role in investment and non-investment projects.

26. To play this role, though, ADB must have (i) innovative instruments and modalities; (ii) sensible ideas (i.e., expert advice) to accompany its money; and (iii) a business model that can accommodate and be accommodated by its development partners, and the private sector. ADB needs to change the focus of its current business model substantially to achieve this. Specifically, ADB must become more client-oriented. The introduction of new instruments and modalities, and the modification of existing ones, is just one part of this change. The financial world is changing faster than ever, particularly in Asia with its huge financial savings. If ADB ignores these trends, it will be marginalized. While Asia has been growing, development banking has not.

27. Another noteworthy market development, beyond the increased accessibility of capital markets to various ADB clients, is the revised Basel II Capital Accord²⁷ for banks. This accord increases the emphasis on risk weightings for credit extended by commercial banks, which impacts on their willingness and ability to provide long-term finance. With its considerable risk-bearing capacity and high credit rating, ADB is a natural partner for banks to develop new cofinancing and partnership modalities. This would increase credit flows to target areas, such as infrastructure and social sector development, and underpin the poverty reduction agenda and attainment of the MDGs.

28. Potential partners would look to ADB to provide funds on a parallel cofinancing basis and to share risks. The market can provide direct funding and ADB credit enhancements through its complementary financing schemes and guarantee instruments. With its regional focus and ability to operate with various instruments (as well as with public and private sector clients), ADB is uniquely positioned to add value by offering integrated financial solutions. The institution can play a key role to mobilize domestic savings and external finance. The inflexibility of ADB’s current policy framework, reflecting a culture of risk aversion and a tendency to be a market follower rather than a leader, prevent it from tapping this potential. The lack of adequate incentive structures, business processes, and practices also discourage the search for appropriate and attractive financing arrangements for investment programs, as opposed to dealing principally with stand-alone project lending. These business processes and practices must be changed. Another IEI proposal focuses on this through the reform of the country strategy and program (CSP) and transaction-based business processes (footnote 1). The proposed financial instruments and modalities are also part of this endeavor. Other institutions have similar limitations, but most are now in the process of changing them.²⁸

C. Issues

29. Clearly, despite the considerable flexibility in ADB’s existing financing instruments framework, a combination of policy restrictions, outdated practices, constraints in the applicability of various products on offer, and deficiencies in terms of staff skills and incentives is undermining ADB’s relevance, responsiveness, and marketability to clients. Ultimately, this affects results. A summary of some key issues (the list is not intended to be exhaustive) follows:

1. Changing client base and decentralization.
   In line with trends in other parts of the world, an increasing number of infrastructure facilities and public services across the Asia and Pacific region are being transferred to local governments. The decentralization process affects states (or provinces), as well as small, medium, and large municipalities. Indeed, the region has more megacities than any other part of the world, and a major share of the population continues to move to the cities. While decentralization and urbanization trends differ across countries, a common denominator is the absence of a corresponding transfer of financial resources.
   
   This situation, if not addressed, eventually will lead to the deterioration in the quality of the public services, increased budget deficits, or both.²⁹ Decentralization means that local government assumes an obligation to deliver these services to end-users in an efficient manner and at an affordable price. End-users have a right to expect that. Thus, local government, and their financing, matter to ADB in the context of its poverty reduction agenda and with regard to key MDGs.³⁰ SOEs are also an important part of the decentralization process. Many already operate outside the central government budget, at least in terms of financing requirements for capital and recurrent expenditures. These companies are undergoing changes through their restructuring into corporations and, in several instances, through partial sales. This process is often accompanied by improved corporate governance, including the autonomous management structures, the appointment and involvement of nonexecutive and independent directors, and adherence to cost recovery and profit or financial sustainability principles. Many of these companies already tap into local and international markets to finance their investment programs. However, more can be done to advance these efforts. ADB currently serves local governments and SOEs through lending with the support of the central government. However, these entities increasingly will become clients in their own right. Relying on sovereign guarantees to finance their development programs and projects no longer will be an automatic choice. New, albeit risk-averse, instruments must be put in place to meet the demand in this market.



2. Focus on investment programs versus project finance.
   Most transactions that ADB finances on a stand-alone project basis form part of a broader, often long-term investment program. Yet, ADB normally does not finance a slice of such investments for longer than 3–5 years. This is a function of business practices, as well as the cost implications of existing instruments. Particular client concerns related to this are the balance sheet impact of ADB’s financing, as well as the commitment fee structure that discourages large scale programs. Given the financial charges made on undisbursed amounts and long implementation periods of most projects, governments tend to favor loans that finance smaller time slices of investments from a financial cost perspective. However, this practice raises interrelated issues. First, financing smaller time slices increases the time and resources required to process operations, which are part of the ‘hidden cost’ of doing business, particularly when the due diligence and documentation is repeated each time as if the project or sector operation were new. Second, an upfront commitment by ADB to finance a larger and longer time slice of an investment program would allow clients to plan more systematically, especially if ADB’s financing were off balance sheet at the outset. To be more programmatic in its investment lending, ADB needs instruments and modalities that would allow that to happen.



3. Financial statement implications.
   Board approval of ADB financing is recognized as a contingent financial commitment (footnoted in the ADB annual report) for the undisbursed amount on the date of approval. This practice affects ADB’s borrowing and lending headroom and cash flow. A significant mismatch between the financing and disbursement schedules is common. The financing also affects the client’s financial statements from the date of loan effectiveness, with contingent liabilities created (which usually may be reported as off balance sheet item). The impact on the client’s financial statements is important, particularly if the client also taps other long-term financing via capital markets and commercial banks. This situation is exacerbated in the case of clients with longer-term investment programs to be financed primarily through non-ADB sources, a situation relevant, but not necessarily confined, to middle-income countries and larger SOEs. The contingent nature of existing financing structures can affect a client’s financial gearing and, ultimately, its ability to secure financing from other sources, especially if this has to be obtained on a limited or nonrecourse basis. To some clients, balance sheet management can be far more important than ADB’s financial charge on its loans. Clients generally welcome ADB’s involvement not only because of the generally attractive financial terms and long tenors ADB can offer, but also because it will help attract additional cofinanciers.³¹ Yet, the strength of the balance sheet would be a distinguishing feature behind a cofinancier’s decision to provide nonrecourse or limited recourse cofinancing.



4. Currency mismatch.
   Most investment projects and sector investment programs generate only local currency revenues. Local government utility operations (water, wastewater, waste management, electricity, and urban transport) fall into this category. Social sector stand-alone projects and investment programs (such as those in health and education) normally do not generate revenues at all. In these and other instances, the viability of the investments would be improved, other things being equal, if ADB extended financing in local currency. ADB would be more relevant, responsive and have better results on the ground if it could help clients cut the currency risks associated with financing investment programs with only local currency revenues. ADB’s Private Sector Operations Department (PSOD) has made inroads into local currency lending. The operations under the public sector window have not followed suit.



5. Instrument range.
   The current range of financial instruments is too narrow for ADB to service clients effectively. E.g., ADB does not refinance operations once they enter the commercial phase. Such operations might include investment projects supported by other institutions with financing plans that have become inappropriate. Such projects might be viable and contribute significantly to development if the financing plan could be restructured. ADB also has difficulty financing long-term slices of investment programs and to effectively apply its instruments in working directly with SOEs and local government entities on a nonrecourse or limited recourse basis. The ADB instrument range also remains narrow and constrained in terms of coinsurance and reinsurance capabilities. A change in instruments characteristics and new modalities are needed to address different investment and client scenarios.



6. Potential for cofinancing and guarantees.
   The relevance of ADB’s assistance is not only defined by the amount of resources it provides from its own account. ADB can also catalyze the mobilization of additional development financing from domestic and other sources. However, the type, nature, and application of ADB’s project financing instruments and modalities can constrain the mobilization of other funds. Institutional incentives, which are not sufficiently supportive of cofinancing, must figure much more prominently in the work carried out during the processing cycle. In particular, new and more innovative risk-sharing partnerships are needed, including reinsurance or the sell-down of loan exposure to third parties after a certain period. This would allow both more flexible balance sheet management for ADB and new forms of crowding in commercial sources, mainly from the private sector, into ADB financed transactions.



7. Costs and charges.
   The financial terms of standard ADB sovereign debt are generally on par with those offered by similar institutions, including the maturity, margin, and front-end fees. However, the ‘all-in‘ cost of ADB financing is affected by the nature and application of its existing instruments, policies, operating procedures and implementation performance, and not easy to calculate despite some simplifications in the past. The contingent liability of at least part of the financing, and the disconnect between the approved amounts and the timing of the disbursements, can increase commitment fees beyond levels acceptable to borrowers. The problem is exacerbated for large investment programs with longer time horizons. The ‘all-in’ cost can be made more transparent and competitive through the introduction and application of alternative instruments and funding structures, as well as further simplification in the fee structure.

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