12 April 2023

Effective Development Banking: Loans or Guarantees?

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.

This Research Paper is published in the framework of the International Research Initiative on Public Development Banks working groups and released for the occasion of the 14th AFD International Research Conference on Development

It is part of the pilot research program “Realizing the Potential of Public Development Banks for Achieving Sustainable Development Goals”. This program was launched, along with the International Research Initiative on Public Development Banks (PDBs), by the Institute of New Structural Economics (INSE) at Peking University, and sponsored by the Agence française de développement (AFD), Ford Foundation and International Development Finance Club (IDFC).

Have a look on the key findings for a quick overview of the research results

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