Chapter 7: Regional Development Banks

An Overview of Banking System

Even in well-equipped countries with 2-3 centuries of banking experience prior to the beginning of their industrial transformation like Turkey, financial intermediation is not always able to provide financing to each activity sometimes due to focusing problems or sometimes economic value issues. In principle, however, inability to finance socially beneficial activities may bring side effects that are disruptive to the financial system. It can also be seen that this lack of financing ability may even lead to financial crises. The weakness of banking system in a country, developing or developed, is a great threat to its financial system as well as to the stability of international financial markets.

Financial institutions mainly perform two important economic tasks: To manage the fund generation and payment mechanisms and to bring investors and savers closer with fund owners and borrowers.

While, on the one hand, financial institutions take in funds as financial instruments, on the other hand, they give out loans. The survival of these institutions depends on their engagement in a fierce competition between other “ fund seeking ” persons or institutions for attracting d epositors’ savings. In the same way, they must compete with “fund lending” persons and institutions too in order to lend those funds out to investors. This situation helps financial markets become specialized while spreading the idea of portfolio management.

Financial Evolution and Banking

The evolution of financial system should be discussed based on structural changes in financial system, activities and instruments over time. As for its level of development, it depends on the financial conditions provided by the system itself, including sufficient integration between sectors, large variety of products, access to information, large number of financial institutions and their number per capita, strong willingness to take risks and finally net interest income from deposits.

The fact that large banks in some countries get a high share of total deposits shows that financial intermediation is, in a sense, being performed under oligopolistic circumstances. According to Fry and Aghevli, number of banks and bank branches per capita are key indicators of monetization and financial intermediation. As lack of competition also means low number of bank branches, an oligopoly does not help absorb non-monetized activities in rural and urban areas. The said phenomenon weakens the relationship between the investor and the saver as well.

Quantitative Measurement of Financial Intermediation

A quantitative measurement of financial intermediation is required to conduct a quantitative analysis of monetization as well as to assess its relationship between financial and monetary policies in order to establish a suitable model (for a typical developing country) that comprises variables closely related to monetization. In light of long-term analysis of monetization, Chandavarkar was able to design a rational model. When we adapt this model of his to 2000s, with an analytical approach and enough empirical clues, we can reach to the following conclusions:

This model can be explained as follows: financial intermediation ratio is directly proportional to the marketing of surplus product in private sector, allowing individuals to earn a side income. Transformation of family members into wage workers would automatically contribute to the monetization as an income-generating activity (Emre Alkin et al, 2001). Considering the fact that personal saving is a variable that is inversely proportional to loan demand, it is inversely proportional to financial mediation, too. Similarly, inclination to unincorporation is also in inverse proportion to financial mediation. Lastly, non-monetary transactions are considered detrimental to financial mediation as well.

Financial Liberalization and Banking

The notion of financial liberalization is defined as the process of reducing or eliminating price and quantity controls over markets, and making economies open to international capital flows. The positive parallelism between financial liberalization and banking becomes more apparent when analysing the impacts of financial liberalization on financial markets. Liberalization of interest rates, in other words, transition to positive real interest rates with the Financial Liberalization, has once again increased the importance of regional banking.

Due to the afore-mentioned standards and technical reasons, commercial banks cannot provide financing for projects aimed at development. Accordingly, it has become necessary to prefer financing these projects through Regional Development Banks because of several reasons including resource costs, proposed loan interests, collateral and capital requirements.

BIS and BASEL Committee

Established in 1974 with concern for the possibility that international capital movements may lead to a global crisis, the Basel Committee for Banking Supervision (BCBS)- the BIS developed into a global meeting place for regulators and for developing international standardshas set forth the issues like business volume of each bank’s capital, whether banks have enough capital to protect themselves from high-risk, and relevant controls, in order to prevent risks that might arise within their own domestic economies.

The 1988 Basel Accord approved by regulators from the G-10 countries is a huge step taken in the risk management process. Although criticized for including decisions only on credit and market risk negotiated by the Group of Ten, the Basel Accord is also considered a significant step towards improving financial stability domestically and internationally. The Basel Committee prepared a document to strengthen the prudential supervision of banking in all world countries.

What is Regional Development Bank (RDB)?

The regional development banks (RDBs) are multilateral financial institutions that provide financial and technical assistance for development in low- and middle-income countries within their regions. Finance is allocated through low-interest loans and grants for a range of development sectors such as health and education, infrastructure, public administration, financial and private-sector development, agriculture, and environmental and natural resource management.

What is the Role of Regional Development Banks?

Prolonged instability of developing countries and the volatility of their access to the global financial markets stand out as two main problems that are leading to a redesign of international financial architecture where the RDBs are playing new roles:

Membership Structure

The RDBs are owned by member governments of both regional and non-regional countries. Each member is a shareholder of the institution. A country’s voting shares and level of board representation are based on the size of its economy and its financial contributions to the institution.

Governance of RDBs

The RDBs have internal organizational structures similar to each other. Run by their own management and staffed by international civil servants, each RDB is supervised by a board of governors, a board of executive directors, and a president. The board of governors is the highest decisionmaking body of an RDB. It consists of one governor for each member country, generally a member country’s secretary of the treasury or minister of finance.

RDBs’ Headquarters

The headquarters of the RDBs are located in their respective region. The ADB headquarters is located in Philippines, with 29 country offices and representative offices in Tokyo, Frankfurt, and Washington, D.C. The AfDB headquarters is located in Côte d’Ivoire; but temporarily relocated in Tunisia due to political unrest in Côte d’Ivoire. The EBRD headquarters is located in in London with 34 county offices in member countries. The IDB headquarters is located in Washington, D.C., with 26 country offices in regional member countries, as well as in Paris and Tokyo.

Lending Mechanism

Most of the RDBs have two main funds called “hard” and “soft” lending windows. The hard lending windows provide financial assistance in the form of loans nonconcessional assistance to middle-income countries, some creditworthy low-income governments, and private firms in developing countries. The soft lending windows provide grants and concessional loans to the region’s poorest governments. Most loans are interest-free and have a maturity of two to four decades. The amount of lending that the RDBs provide depends on demand and it varies from year to year.

Funding Mechanism

The RDBs’ hard and soft lending windows get their funding in different ways. The hard lending windows borrow on international capital markets at reasonable rates and relend the money to developing countries. This lending model uses the advantages of the low rates but slightly raises the price to cover the RDBs’ operational expenses and generate funds for other purposes. The soft lending windows, on the other hand, are financed by contributions from richer countries and are replenished every three to five years. Some RDBs transfer a part of their surplus net income from their non-concessional lending to fund their concessional programs .

Main Objectives of the RDBs

The main objectives of the RDBs are as follows: Helping member countries to develop their domestic financial markets so that they can mobilize their own savings for development purposes; Bringing member countries to global financial markets in a sustainable manner; And making... less severe, with their insufficient resources, the pro-cyclical behaviour of private sources of financing. Achieving these objectives would have involvements in various extensions for the RDBs. RDBs would need to: Develop new financial instruments; Plan and fashion particular lending policies; Bring their capacity to produce and disseminate knowledge/best practices into a more desirable condition.

Dealing with Financial Crises

According to a number of critics of the prevalent financial architecture, providing emergency liquidity should be among the exclusive functions of the IMF. Yet, if development institutions are to avoid these types of operations, the IMF’s liquidity would be substantially increased for the preparation of a contingency plan. If international community does not multiply the liquidity of the IMF in case of emergency, the development banks then would have to contribute using their larger liquidity. Considering the fact that it is not easy to predict the extent of the crisis, it is crucial for RDBs to have prepared policies and instruments beforehand. If RDBs are to continue helping to resolve liquidity problems in financial crises, they should design an instrument specific for this purpose. Countries experiencing financial crises require financing for the two following reasons: Emergency liquidity is needed to restore the confidence of depositors and lenders in the domestic financial system and the government’s ability to repay its obligations; Funds are needed to implement structural reforms designed for preventing the recurrence of the crises. These two problems pose different financial needs. Financing for the first problem should be provided with short maturities, under the assumption that the government and financial system will recover the liquidity.

Crisis Prevention

The tasks set forth involving the integration of the developing countries into global markets should be further developed to prevent crises. Also, the RDBs may expand this objective by supplying another instrument: IMF’s Contingent Credit Line (CCL) introduced in 1999. This facility aims to strengthen member countries’ defences against financial crisis, providing contingent lines of credit to be disbursed in case of a crisis concerning fiscal or monetary indiscipline. The RDBs can engage in contingent operations for the following reasons: First, the size of the IMF facilities is too small to bring comfort to markets. The CCLs are limited to 3-5 times the countries’ quota (Hinds, 2002); Second, other than fiscal or monetary indiscipline/contagion reasons, emergency loans may also be disbursed in cases like natural disaster or terrorist attack, examples of many events that could start a liquidity crisis even in a diligently governed country. Third, only a third of the approved amounts for CCLs can be disbursed automatically. The remainder should be subject to an evaluation of the situation at the moment of loan payment, which would reduce effectively the size of the contingent loan to a third of its nominal value, or about 1-1.6 times the country quota with the IMF.

The Competitive Advantages of the RDBs

Integrating developing countries into the international financial architecture requires coping with four issues: First issue: developing countries have to perform a number of tasks in order to stabilize their economies, like exerting discipline on their fiscal and monetary policies, enhancing their financial systems and diversifying exports via trade liberalization; Second issue: executing the second generation reforms to provide an institutional setting suitable for a modern economy, such as protecting the rule of law, assisting the progress of creating property rights and making sure they are properly carried into effect, providing transparency in economic and political activities, improving financial regulation and monitoring/supervision, reinforcing banks and similar structural reforms; Third issue: countries where the abovementioned tasks have already been achieved or advanced to a large extent will need to defeat the resistance of markets in financing developing countries on a continual basis; Fourth issue: despite the fact that carrying out the above-mentioned tasks would considerably reduce the risk of financial crisis, it may not help eliminate it completely. In this context, countries must establish mechanisms to deal with financial crises, designed to decrease their negative impacts on countries struggling with them and on the rest of the developing countries.

Considering the fact that the World Bank or the RDBs can complement the duties of the IMF, three important questions have to be answered so as to design a new and full-scale international financial architecture:

1. Can the RDBs offer value-added activities to the new financial architecture in addition to activities that are already being provided by the World Bank? RDBs are in a position to offer different and unique value-added activities to the new financial architecture.
2. Should the tasks regarding global financial architecture be formally divided between the World Bank and the RDBs?
3. What type of coordination should exist between the RDBs and the World Bank?

From RDBs to MDBs

The MDBs (multilateral development banks) are among the international community’s immense success stories during post–World War II period. They were established to address a market failure in long-term cash flow to Europe devastated by the conflict and developing countries and they have been integrating financial capacity and technical knowledge for decades to support the investments of borrowing members during post conflict restructuring, growth incentive, and poverty reduction. The geo-economic landscape, however, drastically changed in the 20th century as well as the demands/needs of the developing world. Developing countries now comprise half of the world economy. The capital market failure that originally stimulated the MDBs is less severe. To manage public investment for the most part, now, almost all developing countries depend on domestic resources, and some of the poorest countries can borrow abroad on their own. Similarly, growth and the globalization of professional expertise on development practice have corroded whatever near-monopoly of consultancy services the MDBs once had.

Today, the MDBs do not only exist but they also flourish thanks to growing demand for their services and financing, which however gives a false impression of a crucial need for reinvention if the MDBs are to meet today’s urgent challenges as effective as they possibly can. Notably, the legacy MDBs (the World Bank, the Inter-American Development Bank (IADB), Asian Development Bank (AsDB), African Development Bank (AfDB), and European Bank for Reconstruction and Development) have not been quick to adapt to today’s realities, including the growing economic role and increasing capability of their borrowers.