How should National Development Banks (NDBs) assess the cost-effectiveness of using loans and loan guarantees in order to choose the type of financial instrument most appropriate for each program? We find that the development impact per dollar of fiscal resource required by each instrument largely depends on the kind of market failure that the NDB program addresses. Broadly speaking, theory suggests that the failure of the market to carry out investment projects with high social return due to positive externalities calls for soft loans or subsidy grants to incentivize investors, while poor enforcement of loan repayment or shortcomings of the private financial system to bear risk would generally favor the use of loan guarantees to improve the profitability of private loans to borrowers deemed uncreditworthy.
Agency costs in second-tier operations may justify first-tier operations with a larger scope for lending, including a role for contingent lending with equity participation to reduce the fiscal burden. This stylized benchmark provides a starting point to analyze NDBs’ rationales for instrument choice and assess whether actual financial frictions are sufficiently important to justify deviations from these guidelines.