Supranationals. Multilateral Development Banks: Rating Criteria and Industry Review. Criteria Report

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1 Criteria Report Eric Paget-Blanc, Paris eric.pagetblanc@fitchratings.com Laurent Bergadaa, Paris laurent.bergadaa@fitchratings.com Multilateral Development Banks: Rating Criteria and Industry Review Multilateral Development Banks (MDBs) are supranational financial institutions that aim to provide financial aid to developing countries and promote regional integration in specific geographical zones. Their capital is directly controlled by countries the member countries. MDBs are not subject to any national jurisdiction and to any form of bank regulation; they are governed by their prudential rules and policies defined by member countries. Fitch Ratings has identified five types of MDBs, according to their geographical scope of operations global, regional, European, sub-regional and those whose capital is partly owned by private institutions. Seven out of the 11 MDBs rated by Fitch are rated AAA. MDBs high credit quality is first and foremost attributable to the support from member countries. Support is provided through capital subscribed but uncalled by member countries. This capital can be called up if the bank is unable to meet its debt obligations and constitutes an unconditional commitment from member countries. Fitch places emphasis on the share of uncalled capital subscribed by highly-rated non-borrowing member countries. Ratings assigned to MDBs also take into account the high level of capitalisation of these institutions. To measure capitalisation, Fitch uses the ratio of usable capital to required capital. Usable capital is defined as shareholders equity plus callable capital of non-borrowing member countries and countries rated AA- or higher. Required capital is equal to the expected loss of an MDB s entire portfolio. To compute this figure, Fitch uses the default probabilities associated with the ratings of the Banks assets, with a credit uplift to reflect the MDB s preferred creditor status. Ratings also reflect other intrinsic factors, in particular, asset quality, liquidity, market risks and risk management policies. These factors are assessed using traditional bank analysis indicators. MDBs exhibit modest but stable profitability ratios; they are not viewed as a key rating criterion by Fitch. Although a number of MDBs are exposed to emerging market risks, their asset quality is good overall. However, Fitch notes that the asset quality, as measured by traditional bank ratios, of global and regional MDBs is generally higher than that of sub-regional and privately-owned MDBs, especially those operating in Africa. MDBs main source of risk lies in their high loan concentration, which far exceed the limits set by commercial bank regulations. To measure risk concentration, Fitch calculates the weighting of the five largest loans as a proportion of the MDB s total portfolio and its equity. 15 June

2 Table 1: Main Multilateral Development Banks Total Assets (2003) and Member States Bank Name Total Assets (USDm) Head Office Borrowing Member States European Investment Bank (EIB) 295,628.2 Luxembourg EU countries + developing countries partners of EU International Bank for Reconstruction and Development 227,423.0 Washington Developing countries worldwide (IBRD) Inter-American Development Bank (IADB) 69,244,4 Washington Latin American countries Asian Development Bank (AsDB) 52,468.2 Manila Developing Asian countries International Finance Corporation (IFC) 32,361.0 Washington Developing countries worldwide European Bank for Reconstruction and Development (EBRD) 27,815.2 London Eastern and Central European countries Nordic Investment Bank (NIB) 21,048.6 Helsinki Nordic countries Council of Europe Development Bank (CEB) 18,671,1 Paris European countries member of Council of Europe African Development Bank (AfDB) 14,848.0 Abidjan* African countries Corporacion Andina de Fomento (CAF) 8,817.6 Caracas Bolivia, Colombia, Ecuador, Peru Venezuela Islamic Development Bank (IDB) 6,456.0 Jeddah Muslim countries worldwide Central American Bank for Economic Integration (CABEI) 3,567.7 Tegucigalpa Costa Rica, Guatemala, Honduras, Nicaragua, Salvador Banco Latinoamericano de Exportaciones (Bladex) 2,534.6 Panama City Latin American non public institutions Fondo Latinoamericano de Reservas (FLAR) 2,021.8 Bogota Andean countries + Costa Rica West African Development Bank (WADB) Lome West African Economic Community countries Caribbean Development Bank (CDB) Bridgetown Caribbean States African Export-Import Bank (Afreximbank) Cairo African non public institutions Black Sea Trade and Development Bank (BSTDB) Thessaloniki Black-Sea countries East African Development Bank (EADB) Kampala Non public institutions in Kenya, Uganda and Tanzania Eastern and Southern African Trade and Development Nairobi Eastern and Southern African States Bank (PTA Bank) * Temporarily relocated in Tunis Note: this list does not include MDBs that are still at an early stage of operations, such as the North American Development Bank or the Central African Development Bank. Neither does it include subsidiaries, such as the European Investment Fund, and funds managed by MDBs Source: Banks financial statements Overview of the MDB Industry Multilateral development banks (MDBs) are supranational financial institutions that aim to provide financial and technical assistance for projects of a social nature, by raising funds on the financial markets. Their capital is directly controlled by countries the member countries though some MDBs have invited private institutions to participate in their capital. MDBs are not strictly speaking banks: they are not subject to the jurisdiction of any country and, as a consequence, are not subject to any form of bank regulation; they are governed by their prudential rules and policies defined by member countries. MDBs do not seek to maximise profit and generally do not distribute dividends. MDBs benefit from preferred creditor status: they do not participate in Paris Club sovereign debt rescheduling and the reimbursement of sovereign debt due to MDBs takes precedence over other creditors. MDBs play a crucial role in channelling official development aid to emerging countries. The creation of new regional banks in the 1990s Afreximbank, BSTDB, PTA Bank and the North American Development Bank (in the US Mexico border Zone) provided clear evidence of the potential that these types of institutions have for financing development. Indeed, MDBs help developing countries to raise hard currency funding on excellent terms, which they would not otherwise obtain on their own. They also allow wealthy countries to fund development without committing significant funds, as most MDBs funds are raised on the financial markets. Other supranational entities are involved in the financing of development, but cannot be considered as MDBs, mainly because of their legal structure. This is the case of EURATOM and the European Community, both rated AAA by Fitch. These institutions are not covered in the MDBs review, but are presented individually in the second part of the report. Supranational institutions are among the largest bond issuers on the international financial markets. Overall, issues from supranational institutions accounted for 3.4% of outstanding global issues, as of 3 May 2005 (source: Bondware). Together, the 2

3 EIB and the IBRD account for some 70% of total supranational outstanding bond issues. The Different Types of MDBs The MDB industry can be split into five categories: Global MDBs These provide financing to all developing countries worldwide. Their ownership structure includes both borrowing members generally developing countries and non-borrowing members mostly industrialised countries and they extend financing to all countries worldwide. This category includes only two MDBs: the International Bank for Reconstruction and Development (IBRD), which makes loans to sovereign entities only, and the International Finance Corporation (IFC), which specialises in private-sector financing. Both are part of the World Bank Group. The IBRD s lending is exclusively to the public sector and takes the form of budgetary aid to states (generally associated with IMF aid packages) or the financing of governmentsponsored projects (infrastructure, industry or projects of a social nature). Regional MDBs Their ownership is split between non-borrowing and borrowing members, the latter holding a majority of the capital. Unlike the global MDBs, their range of activities is restricted to a specific region. This category includes the AfDB, the AsDB and the IADB. In common with global MDBs, loans are predominantly extended to the public sector. European MDBs These MDBs have member countries based in Europe and need to be distinguished from other regional MDBs, as they grant loans to countries that are either already developed or are in transition to being market economies. This group includes the COE, the EBRD, the EIB and the NIB. These MDBs extend a significant portion of their loans to the private sector, local authorities and financial institutions, except the COE and the EBRD, which still have large exposure to sovereign borrowers. EIB and NIB financing is primarily aimed at funding the social and economic integration of the European Union (EU) member states; they are also involved, to a lesser extent, in financing developing countries that have signed partnership agreements with the EU. Financings granted by the EBRD and, increasingly by the COE, are oriented towards Central and Eastern Europe (CEE). However, a large share of the COE s activities include wholesale financing to EU financial institutions. Sub-Regional MDBs Borrowing members hold a large majority of capital. However, ownership may include some nonborrowing members with a limited share of capital. This is the case for BSTDB, CABEI, CAF, FLAR, CDB, EADB, IDB, PTA Bank, and WADB. Subregional banks enable member countries to raise hard currency funding on much more advantageous terms than they would obtain separately and to redistribute them in local economies without the constraining conditions imposed by global or regional banks. Privately-Owned MDBs Some sub-regional banks African Export and Import Bank (Afreximbank) and Banco Latinoamericano de Exportaciones (Bladex) are controlled by both states and private financial institutions. Their loans are mostly directed towards the private sector. In many respects, these MDBs have the same features as commercial banks. Private Sector Activity Although MDBs on aggregate are specialised in sovereign lending, they also and increasingly operate in the private sector, to varying degrees. Private sector financing takes the form of loans, equity stakes or guarantees. The use of guarantees, though still marginal in relative terms, is growing steadily. MDB Private Sector Financing Private Sector Exposure/Total Exposure* (%) AfDB 5.2 AsDB 2.8 CABEI 36.5 CAF 12.3 COE 35.0 EADB EBRD 79.5 EIB 43.4 IADB 3.0 IBRD 1.2 IDB 24.5 * Exposure = Outstanding gross loans + equity investments + outstanding guarantees Source: Bank s financial statements and Fitch Loans to the public sector are generally granted by the MDBs on advantageous terms; a single lending rate is applied to all borrowers, regardless of their risk profiles. In most instances the loans are long term, with the interest rate determined by the MDB s refinancing costs, augmented by a spread. However, in the case of loans to the private sector, MDBs set conditions according to the credit quality of the borrowers, and spreads are substantially higher than for public sector borrowers. The regional and subregional MDBs share of private-sector financing tended to increase in the last decade. Some MDBs, such as the IFC, the EADB, Bladex and Afreximbank, operate exclusively with the private sector, or, in certain cases, with enterprises partly government-owned. European 3

4 MDBs extend a large share of their financing to the private sector. As MDBs do not have their own branch networks, they extend the loans to large corporations or to commercial banks, which redistribute them to local businesses. Some MDBs also purchase equity stakes in private firms or shares of mutual funds investing in a private firm s equity. A number of MDBs have created separate subsidiaries dedicated to private sector investment. This is the case for the Inter-American Development Bank, which created the Inter-American Investment Corporation, the IDB which created the EFS and the ICD and the EIB which established the European Investment Fund (which specialises in venture capital funding). Fitch expects growth in private sector financing to continue, as industrialised countries have encouraged private sector financing to complement public sector aid. This trend has seen the role of MDBs gradually shifting away from granting public sector aid to leveraging private sector funds. This will have a negative effect on the asset quality of MDBs, except for those lending to European borrowers, which benefit from the gradual improvement in the credit quality of both private and public sector borrowers in the EU. Concessional Lending Global and regional MDBs do not grant loans to the poorest countries directly. Lending on market conditions is restricted to countries that are declared eligible, based on their capacity to honour debt service. However, non-eligible countries may have access to development aid either through regional MDBs or through development funds managed by global MDBs. These funds, which are financially independent from the MDBs, distribute concessional loans (with a maturity of 20 to 40 years and interest rates below the bank s cost of fund) to countries not eligible for direct loans. They are funded by contributions from donors (mainly developed countries). The largest concessional financing fund is the International Development Association (IDA), which is managed by the IBRD. It is followed by the Asian Development Fund (managed by the AsDB), the African Development Fund (AfDB) and the Fund for Special Operations (IADB). The Persian Gulf countries have also created several such funds (the Arab Fund for Economic and Social Development, the Arab Bank for Economic Development in Africa and the Kuwait Fund for Arab Economic Development) that are used to finance development in the poorest Arabic or African countries. Another fund, the International Fund for Agricultural Development, has been set up by industrialised countries to finance the development of agriculture in poor countries. Ratings are Primarily Based on the Support from Member Countries As of April 2005, Fitch rated 11 MDBs (this does not include the ratings of the European Investment Fund, a subsidiary of EIB, and the European Community and EURATOM). Seven have been assigned a Long-term rating of AAA ; only one has a speculative grade rating (see Table 2). The MDBs high credit quality is based first and foremost on the support they receive from member states. This support is granted through a specific mechanism: capital subscribed by member states far exceeds paid-in capital, sometimes as much 15 times. Socalled callable capital constitutes an unconditional commitment from member states to pay in capital were the MDB unable to repay its debt obligations. To date, no MDB has been forced to make use of its callable capital. When analysing support from member states, Fitch identifies which countries are most willing to provide support in case of need. This group of countries constitutes the MDBs reference shareholders. In Fitch s approach to rating MDBs, the rating of the bank should not, as a general rule, be lower than that of the average rating of the reference shareholders adjusted (i.e. plus or minus a certain number of rating notches) to reflect the reference shareholders willingness to support the bank. For global or regional MDBs, the non-borrowing members, mostly highly-rated wealthy countries, such as the US, Japan, Germany, France and the UK, control a significant share of the capital of the banks, and are considered as reference shareholders. European MDBs reference shareholders also include highly-rated European countries (and some non-european in the case of the EBRD). This largely explains why these institutions are rated AAA. The ownership of sub-regional MDBs is dominated by developing countries, though some of these institutions, such as CABEI or CAF, have convinced some highly-rated non-borrowing members, such as Spain, to participate in the capital. However, their ownership remains limited, and these members cannot be considered reference shareholders. The reference shareholders are the group of borrowing members with the largest share of capital. However, as illustrated by the cases of CABEI, CAF and the IDB, Fitch has assigned these institutions ratings higher than the average rating of their reference shareholders (the Central American countries, Andean countries and Persian Gulf countries, respectively). This rating premium reflects intrinsic factors, in particular, their levels of capitalisation, 4

5 Table 2: Support from Member Countries and Capital Adequacy of MDBs Rated by Fitch, End-2003* (%) AfDB AsDB CAF CABEI COE EADB EBRD EIB IADB IBRD IDB Fitch Long-Term Rating AAA AAA A BBB+ AAA B- AAA AAA AAA AAA AA Usable Capital/Required Capital (x) Paid-in Capital/Subscribed Capital (%) Share of Non-Borrowing Members & Borrowing Members Rated AA / AAA in Capital Equity/Assets (%) * IBRD: End-June 2003 IDB: 20 Feb 2004 Source: Bank s financial statements and Fitch their asset quality and their financial and credit risk policies. Reference shareholders of privately-owned MDBs include both commercial banks and sovereign entities. As of April 2005, no such MDB was rated by Fitch. Ratings are Also Supported by MDBs High Levels of Capitalisation The support from shareholders is also reflected in the bank s capitalisation, as support takes the form of subscribed but uncalled capital. Fitch has devised its own capital adequacy ratio usable capital to required capital which encapsulates the MDBs assets quality and shareholder support. Other ratios used to measure capital adequacy are listed in Annex 1. Usable Capital Is equal to the sum of equity, callable capital from non-borrowing investment grade rated countries and callable capital from borrowing countries rated AA- or more. It represents the likely cushion that MDBs have at their disposal to absorb credit losses. Required Capital Represents the total expected loss on the loan, equity, guarantee and liquid assets portfolios. It is equal to the sum of the expected loss of each type of exposure. For loans, guarantees and liquid assets, the expected credit loss (ECL) is defined as the exposure at risk (EAD) times the default probability (PD) times the loss given default (LGD): ECL = EAD x PD x LGD With: EAD = the gross outstanding amount of the exposure; PD = the stressed 1 default probability associated with the rating of the exposure (see below) 2 assigned by Fitch (ten year default probabilities are used); LGD = 50% (derived from the 45% rate recommended in Basel II banking regulations). Net equity participations are then added and loan loss provisions are deducted to obtain the Required capital. Required capital = ECL + Net equity participations Loan loss provisions The ratio of broad 3 capital to required capital is computed, but Fitch attaches more importance to the ratio of usable capital to required capital described above, as it takes into account support from nonborrowing member countries or from highly-rated borrowing countries only. Fitch also uses traditional measures of banks capital adequacy, such as the ratio of equity to assets and the ratio of total exposure (loans + guarantees + equity investments) to total capital (subscribed capital plus reserves). Basel G10 ratios are not often available (they are only made available by CAF and CABEI). The analysis of capital adequacy ratios indicates that, overall, MDBs are highly-capitalised institutions, as illustrated by high ratios of equity to assets and ratios of usable capital to required capital well above 1. Global and regional banks exhibit the highest levels of capitalisation, with usable capital covering, in two cases, more than 10 times the required capital (see Table 2). The IADB s ratio stands below that of other regional MDBs, mainly as a result of its high exposure to Argentina. 1 Stressed defaults probabilities are equal to the observed default probabilities multiplied by a risk coefficient which is based on more severe assumptions about default risk. 2 The rating associated with sovereign exposures is equal to the sovereign rating plus three notches (see Box 1). If the rating of the exposure is not publicly available, it is estimated by Fitch s analysts. 3 Broad capital now replaces the term available capital. For a definition of this ratio, see Risk analysis of multilateral development banks and other supranationals, Fitch Ratings Criteria Report, March

6 Sub-regional banks appear less capitalised: their ratio of usable capital to required capital is comprised between 1.11 (EADB) and 3.43 (IDB). This reflects the lower quality of shareholders, as callable capital from borrowing member countries and from member countries rated lower than AA- is excluded from usable capital. The capital ratios of European MDBs, on the other hand, benefit from the high credit quality of their shareholders, whose callable capital offsets modest ratios of equity to asset (10% for COE and EIB). With required capital 13.6 times covered by usable capital, EIB is the strongest MDB in terms of capitalisation. MDBs' Aggregate Capitalisation (USDbn) Total Assets (LHS) Equity/Assets (RHS) Note: Aggregate numbers are obtained from accounting data of the 11 MDBs rated by Fitch listed in Table 2. Source: Fitch (%) Despite a steady increase in assets, particularly in the late 1990s, at the peak of the emerging market crisis, the capitalisation of MDBs improved, thanks to their ability to generate stable levels of profitability and the fact that their earnings are not distributed. Also, several banks convinced their shareholders to increase capital, in particular the AfDB, CAF and CABEI. and Intrinsic Factors, Mainly Asset Quality, Risk Concentration, Liquidity, Leverage, Profitability and Internal Risk Management Policies Evaluation of Asset Quality MDBs loan portfolios are marked by significant exposure to emerging countries, with the exception of the EIB and the NIB. This is not because of their particularly high risk appetite, but is linked to their role, which is to lend to borrowers that do not have access to cheap market funding. To assess asset quality, Fitch has resorted to traditional ratios used for financial institutions (see Annex 1): non accrual loans to gross loans, loan loss reserves to gross loans, loan loss reserves to non-accrual 4 loans, share of loans to investment-grade borrowers. The ratio of allowances for losses to equity investments is also computed to reflect the risk of equity stakes held by MDBs. Overall, the level of non-accrual loans is low and very well covered by provisions. MDBs with the highest levels of impairment are those involved in private-sector lending, such as the IFC, Bladex and the EADB. Substantial differences in asset quality also exist between MDBs operating in Western Europe, which face extremely low levels of arrears, as they extend financing mostly to EU-based institutions, and other MDBs, which lend predominantly to emerging countries. Generally, global and regional MDBs have relatively good asset quality, in particular the AsDB and the IADB, which have not suffered significant defaults on public sector lending in recent years, and the IBRD, which has cleared, using donors aid, its largest arrears. In contrast, the AfDB recorded a significant increase in arrears between 2000 and 2003, as a consequence of the default of several large African sovereign borrowers (Gabon in 1999 and Côte d Ivoire and Zimbabwe in 2000). Indeed, all MDBs operating in Africa Afreximbank, the AfDB, the EADB, the WADB and PTA Bank saw their asset quality deteriorate in the early 2000s, as a result of the political crises in Côte d Ivoire and Zimbabwe. This led Fitch to downgrade its ratings of EADB in Box 1: The Preferred Creditor Status Preferred creditor status is not based on law or regulation: it is a de facto status, which applies to MDBs sovereign borrowers only. It means that the repayment of MDBs loans takes precedence over other creditors in the event of a sovereign default. This also means that in case of a sovereign external debt crisis, the central bank would grant priority access to FX reserves to companies wishing to reimburse MDBs loans. MDBs also do not reschedule or write-off sovereign loans. To take account of preferred creditor status, Fitch raises the ratings of sovereign borrowers by three notches when calculating required capital. This reflects the fact that the probability of default on a preferred creditor obligation is lower than on any other senior-unsecured liability (see Rating structured transactions with a World Bank guarantee, Fitch Ratings International Comment, October 2000). 4 Doubtful loans of MDBs are referred as non accrual loans, as MDBs stop accruing interest on loans when they have been in arrears for a certain period (three to six months). 6

7 MDB s good asset quality is attributable to the preferred creditor status that all MDBs benefit from (see Box 1). However, the number of exceptions is growing: IDB accepts the principle of loan rescheduling; the IBRD also agreed to reschedule loans in the 1990s (to Bosnia Herzegovina and to Serbia-Montenegro), and both the IBRD and the AfDB recently agreed (without however suffering any loss) to clear the arrears of the Democratic Republic of Congo (DRC). Preferred creditor status was successfully tested following the Argentina crisis, when the sovereign agreed to honour with a delay the repayment of loans from the IADB and the IBRD, while at the same time it imposed strict currency controls and refused to allow repayment of private sector loans denominated in foreign currencies. As explained above, the preferred creditor status is treated by Fitch in the calculation of its capital ratio, by adding three notches to the rating of sovereign exposures. MDBs' Aggregate Asset Quality Non Accrual Loans/Gross Loans (LHS) (%) Loan Loss Reserve/Gross Loans (RHS) (%) Source: Fitch After deteriorating in the late 1990s, as a consequence of a series of crises in emerging markets (see A Survey of Multilateral Development Banks and their Responses to the Successive Emerging Market Crises, Fitch ratings International Comment, March 2003), MDBs asset quality has significantly improved in recent years. This is largely owing to the recovery of the economies in Asia and Eastern Europe, but also to the implementation of the Heavily Indebted Poor Countries (HIPC) Initiative and other arrears clearance operations (such as in the DRC), especially for MDBs exposed to the poorest countries, in particular the AfDB, CABEI, CAF, the IADB and the IBRD. This initiative allowed the countries for which external debt is viewed as non sustainable to benefit from significant debt relief from the financial community. This debt relief is mostly financed by bilateral donors, through a World Bank managed trust fund; the cost for MDBs is negligible, while it MDB Concentration, End-2003 Five Largest Exposures/Total Exposure* (%) Largest Exposure Largest Exposure/Total Equity (%) AfDB Tunisia AsDB Indonesia COE KfW CABEI El Salvador CAF Colombia EADB n.a EBRD Romania 5.43 EIB n.a IADB Brazil IBRD China IDB Bangladesh 6.31 * Total exposure = Gross loans + outstanding guarantees + equity stakes Source: Bank s financial statements and Fitch has helped cut significantly loans placed in nonaccrual status. Assessment of Risk Concentration To assess risk concentration, Fitch examines the share of the MDB s single-largest exposure in its total loan portfolio. It also compares the share of a bank s five largest loans to shareholders equity. The agency also observes the strategy adopted by the bank to diversify credit risk. The development of private sector lending (see Private sector lending) has been, so far, the MDBs main response to the call for greater risk diversification. One of the largest sources of risk for MDBs is their high level of loan concentration. This is due to the relatively low number of potential sovereign borrowers, especially for sub-regional MDBs. A bank such as CABEI is authorised to extend sovereign loans to only five countries. No MDB except the EBRD and the IDB involved in public sector lending would comply with the concentration limit set by bank regulation were it applicable, since this would require exposure to any one debtor to be less than 25% of its shareholders equity. Some large borrowers constitute a threat to the largest global and regional MDBs owing to the size of their exposure in proportion of shareholders equity : that is the case of Brazil with the IADB, Indonesia with the AsDB, and Tunisia with the AfDB. In contrast, risk concentration is far less dramatic for the MDBs involved in private sector financing, in particular the EADB and the EBRD, as their portfolio is made up of a larger number of smaller exposures. Measures of Liquidity Liquidity management is a key concern for MDBs, as they invest mostly in long-term projects with an average maturity often exceeding five years. Once projects are approved, funds are disbursed over the life of a project; hence, an MDB has to maintain a 7

8 sufficient cash cushion to meet disbursement needs. The problem comes from the fact that MDBs do not collect deposits and are generally reluctant especially those rated in the AAA category to use credit lines from other banks, as their cost is significantly higher than their average funding costs. Hence, to maintain a high level of liquidity, MDBs keep a portfolio of liquid assets that are made up of bank deposits or high-grade securities with short term maturities though some invest part of their portfolios in medium/long-term assets. These portfolios generate low returns, and are exposed to the risk of a decline in interest rates. However, as AAA rated MDBs are able to raise funds at excellent market rates, the net margin generated by the liquid assets portfolio remains positive. Maintaining a portfolio of high-quality liquid assets is more costly for the lower-rated MDBs; they tend to allow more risk taking on portfolio management, and also try to negotiate credit lines with international banks to enhance liquidity. Fitch measures the degree of liquidity of MDBs by comparing the liquid assets portfolio to the stock of undisbursed loans (see Annex 1). Other standard measures of bank liquidity are also applied, such as the ratio of liquid assets to short-term debt and the ratio of liquid assets to total assets. The ratio of liquid assets to total assets is particularly high for MDBs involved in private sector lending, in particular, the IFC and the EBRD, and for banks which recently started operations, such as the BSTDB. Fitch also takes into account the degree of leverage used by a bank, in order to assess its ability to repay debt with capital resources only, in a scenario where it would be unable to generate cash from operations and it would call all its subscribed capital (it is implicitly assumed here that all shareholders would respond to the capital call). Leverage is measured by comparing outstanding debt to total capital and to callable capital. To complete this analysis, Fitch evaluates the bank s debt servicing by comparing pre-interest earnings to annual interest payments (coverage ratio). Leverage Fitch also takes into account the degree of leverage used by a bank, in order to assess its ability to repay debt with capital resources only, in a scenario where it would be unable to generate cash from operations and it would call all its subscribed capital (it is implicitly assumed here that all shareholders would respond to the capital call). Leverage is measured by comparing outstanding debt to equity, debt to total capital, and debt to callable capital (see Annex 1). To complete this analysis, Fitch evaluates the bank s debt servicing by comparing pre-interest earnings to annual interest payments (coverage ratio). Profitability Analysis Although their objective is not to maximise profits, MDBs must generate sufficient interest margins to cover their overheads and loan losses, and also to strengthen equity. Traditional profitability indicators, such as ROE, ROA, cost to income ratio and cost of risk, are used to assess an MDB s profitability (see Annex 1). Other measures are specific to MDBs, in order to evaluate separately the profitability from credit operations (net interest revenues + commitment fees / gross loans + guarantees) and from equity investments (income from equity investments / equity investments). MDBs profitability, as measured by ROE and ROA, indicate that, overall, MDBs have recovered from the late 1990s profit decline, attributable to the successive emerging market crises (Russia and South-east Asia). The increase in profitability also reflects the improvement in asset quality, which allowed the banks to reduce their provisioning charges. However, the implementation of new accounting rules for off-balance sheet instruments (IAS39 and FAS133) resulted in heightened volatility in earnings; this has been particularly the case for the IBRD, which recorded a net loss in 2003/04, after exhibiting a 16% ROE in the previous year. MDBs' Aggregate Profitability (%) Source: Fitch ROA (LHS) ROE ( RHS) The ratio of net interest revenues plus commitment fees to gross loans plus guarantees offers a more accurate picture of profit generated from credit activity. This ratio is high for MDBs that are more heavily involved in private sector activity (the EBRD, the EADB, CABEI), where interest spreads are comparable with those charged by commercial banks. However, these institutions have to record higher provisions; in the case of the EADB, provisions accounted for 2.9% of loans in 2003, and were the primary cause of the losses incurred in the last three years. In contrast, as MDBs have no networks, they (%)

9 have relatively low overheads, and their cost to income ratios are significantly lower than that of commercial banks. Appraisal of Risk Management Policies MDBs credit quality also relies on stringent risk management policies. As they are not subject to any banking regulations, MDBs apply prudential ratios defined by their by-laws or by their Board of Governors. These ratios, which differ from one institution to another, set prudential limits regarding capitalisation, leverage, liquidity, counterparty risk, as well as exchange and interest rate risk 5. Fitch carefully reviews these policies, comparing the main indicators and benchmarks retained by each MDB to assess credit and market risks, liquidity and capital adequacy. Credit Risk Particular attention is given to the rules used by MDBs to account for impaired loans (or nonaccruals, as MDBs do not accrue the interest revenues of non-performing loans), which may differ from one MDB to another. The agency also examines the internal procedures used to approve loans and other types of financing, and at the frequency of project reviews. Market Risks Fitch reviews the rules governing interest rate risk and exchange rate risk hedging. Generally, MDBs by-laws do not allow security trading, and foreign currency positions need to be covered. The limits set are far more conservative than that of commercial banks, and MDBs are not exposed to market risks. Liquidity The benchmark used to measure liquidity is a key issue when analysing internal procedures and rules. Fitch also pays attention to the limits set, both in terms of maturity and quality, to the securities included in the liquid assets portfolio. Capital Adequacy Most MDBs introduce their own measures of capital adequacy; it is, in most cases, a ratio comparing assets to a measure of capital. These ratios differ from the one used by Fitch. However, the agency places importance on an MDB s self imposed limits, as they constitute a measure of its risk appetite for the future. 5 A list of these ratios is provided in Risk analysis of multilateral development banks and other supranationals, Fitch Ratings, March

10 Annex 1: MDBs Comparative Data, Key Ratios 2003 AFDB ASDB CAF CABEI COE EADB EBRD EIB IADB IBRD IDB I. PROFITABILITY LEVEL 1. Net Income/Equity (Av.) % Net Income/Total Assets (Av.) % Net Interest Revenue + Commitment Fees/Gross Loans % (Av.) + Liquid Assets (Av.) + Guarantees (Av.) 4. Non-Int. Exp./ Net Interest Rev. + Other Operating Income % Income from Equity Investment/Equity Investment (Av.) % n.a. n.a n.s n.a. n.a Provision on Loans & Equity Part. & Guarantees/Gross % Loans (Av.) + Equity Investment (Av.) + Guarantees (Av.) II. CAPITAL ADEQUACY 1. Outstanding Loans + Net Equity Invest. + Net Guarantees/ % Subscribed Capital + Reserves 2. Equity/Total Assets % AAA-AA- Callable Capital/Callable Capital % Broad Capital/Required Capital % , III. LIQUIDITY 1. Liquid Assets & Marketable Debt Securities/Debt < 1 Year % n.a. 2. Liquid Assets & Marketable Debt Securities/Total Assets % Liquid Assets + Marketable Debt Securities/Undisbursed % Loans and Equity IV. ASSET QUALITY 1. Non Accrual Loans/Gross Loans % n.a. n.a n.a n.a. 2. Loan Loss Reserves/Gross Loans % Equity Loss Reserves/Equity Investment % n.s. n.a n.a. n.a Total Reserves/Gross Loans, Equity Investment & % Guarantees 5. Loan Loss Reserves/Non Accrual Loans % , , n.a. n.a n.a n.a. 6. Loans to Investment Grade Borrowers/Gross Loans % V. LEVERAGE 1. Debt/Equity % Debt/Subscribed Capital + Reserves % Debt/Callable Capital % Net Income + Interest Paid/Interest Paid % , Note: Aggregate numbers are obtained from accounting data of the 11 MDBs rated by Fitch listed in Table 2. * For CABEI and IBRD, figures are from financial year ended 30 June For IDB, figures are from financial year 1424H ended 20 February All other banks' financial years end on 31 December Source: Banks financial statements and Fitch 10

11 Key Ratios 2002 AFDB ASDB CAF CABEI COE EADB EBRD EIB IADB IBRD IDB I. PROFITABILITY LEVEL 1. Net Income/Equity (Av.) % Net Income/Total Assets (Av.) % Net Interest Revenue + Commitment Fees/Gross Loans % (Av.) + Liquid Assets (Av.) + Guarantees (Av.) 4. Non-Int. Exp./ Net Interest Rev. + Other Operating Income % Income from Equity Investment/Equity Investment (Av.) % n.a. n.a n.s n.a. n.a Provision on Loans & Equity Part. & Guarantees/Gross % Loans (Av.) + Equity Investment (Av.) + Guarantees (Av.) II. CAPITAL ADEQUACY 1. Outstanding Loans + Net Equity Invest. + Net Guarantees/ % Subscribed Capital + Reserves 2. Equity/Total Assets % AAA-/AA- Callable Capital/Callable Capital % Broad Capital/Required Capital % III. LIQUIDITY 1. Liquid Assets & Marketable Debt Securities/Debt < 1 Year % n.a. 2. Liquid Assets & Marketable Debt Securities/Total Assets % Liquid Assets + Marketable Debt Securities/Undisbursed % Loans and Equity IV. ASSET QUALITY 1. Non Accrual Loans/Gross Loans % n.a. n.a n.a n.a. 2. Loan Loss Reserves/Gross Loans % Equity Loss Reserves /Equity Investment % n.s. n.a n.a. n.a Total Reserves/Gross Loans, Equity Investment & % Guarantees 5. Loan Loss Reserves/Non-Accrual Loans % n.a. n.a n.a n.a. 6. Loans to Investment Grade Borrowers/Gross Loans % V. LEVERAGE 1. Debt/Equity % Debt/Subscribed Capital + Reserves % Debt/Callable Capital % Net Income + Interest Paid/Interest Paid % n.s. Note: Aggregate numbers are obtained from accounting data of the 11 MDBs rated by Fitch listed in Table 2. * For CABEI and IBRD, figures are from financial year ended 30 June For IDB, figures are from financial year 1423H ended 03 April All other banks' financial years end on 31 December Source: Banks financial statements and Fitch 11

12 Key Ratios 2001 AFDB ASDB CAF CABEI COE EADB EBRD EIB IADB IBRD IDB I. PROFITABILITY LEVEL 1. Net Income/Equity (Av.) % Net Income/Total Assets (Av.) % Net Interest Revenue + Commitment Fees/Gross Loans % (Av.) + Liquid Assets (Av.) + Guarantees (Av.) 4. Non-Int. Exp./Net Interest Rev. +Other Operating Income % Income from Equity Investment/Equity Investment (Av.) % n.a. n.a n.s. n.a n.a. n.a Provision on Loans & Equity Part. & Guarantees/Gross % Loans (Av.) + Equity Investment (Av.) + Guarantees (Av.) II. CAPITAL ADEQUACY 1. Outstanding Loans + Net Equity Invest. + Net Guarantees/ % Subscribed Capital + Reserves 2. Equity/Total Assets % AAA-AA- Callable Capital/Callable Capital % Broad Capital/Required Capital % III. LIQUIDITY 1. Liquid Assets & Marketable Debt Securities/Debt < 1 Year % n.a. 2. Liquid Assets & Marketable Debt Securities/Total Assets % Liquid Assets + Marketable Debt Securities/Undisbursed % n.a Loans and Equity IV. ASSET QUALITY 1. Non Accrual Loans/Gross Loans % n.a. n.a n.a n.a. 2. Loan Loss Reserves/Gross Loans % Equity Loss Reserves /Equity Investment % n.s. n.a n.a. n.a Total Reserves/Gross Loans, Equity Investment & % Guarantees 5. Loan Loss Reserves/Non Accrual Loans % n.a. n.a n.a n.a. 6. Loans to Investment Grade Borrowers/Gross Loans % V. LEVERAGE 1. Debt/Equity % Debt/Subscribed Capital + Reserves % Debt/Callable Capital % Net Income + Interest Paid/Interest Paid % n.s. Note: Aggregate numbers are obtained from accounting data of the 11 MDBs rated by Fitch listed in Table 2. * For CABEI and IBRD, figures are from financial year ended 30 June For IDB, figures are from financial year 1422H ended 14 April All other banks' financial years end on 31 December Source: Banks financial statements and Fitch 12

13 Key Ratios 2000 AFDB ASDB CAF CABEI COE EADB EBRD EIB IADB IBRD IDB I. PROFITABILITY LEVEL 1. Net Income/Equity (Av.) % Net Income/Total Assets (Av.) % Net Interest Revenue + Commitment Fees/Gross Loans % (Av.) + Liquid Assets (Av.) + Guarantees (Av.) 4. Non-Int. Exp./ Net Interest Rev. +Other Operating Income % Income from Equity Investment/Equity Investment (Av.) % n.a. n.a n.s. n.a n.a. n.a Provision on Loans & Equity Part. & Guarantees/Gross % n.a Loans (Av.) + Equity Investment (Av.) + Guarantees (Av.) II. CAPITAL ADEQUACY 1. Outstanding Loans + Net Equity Invest. + Net Guarantees/ % Subscribed Capital + Reserves 2. Equity/Total Assets % AAA-/AA- Callable Capital/Callable Capital % Broad Capital/Required Capital % n.a III. LIQUIDITY 1. Liquid Assets & Marketable Debt Securities/Debt < 1 Year % n.a n.a. 2. Liquid Assets & Marketable Debt % Liquid Assets + Marketable Debt Securities/Undisbursed % n.a Loans and Equity IV. ASSET QUALITY 1. Non Accrual Loans/Gross Loans % n.a. n.a n.a n.a. 2. Loan Loss Reserves/Gross Loans % Equity Loss Reserves/Equity Investment % n.s. n.a n.a. n.a Total Reserves/Gross Loans, Equity Investment & % Guarantees 5. Loan Loss Reserves/Non Accrual Loans % n.a. n.a n.a. 4, n.a. 6. Loans to Investment Grade Borrowers/Gross Loans % V. LEVERAGE 1. Debt/Equity % , Debt/Subscribed Capital + Reserves % Debt/Callable Capital % , Net Income + Interest Paid/Interest Paid % n.s. Note: Aggregate numbers are obtained from accounting data of the 11 MDBs rated by Fitch listed in Table 2. * For CABEI and IBRD, figures are from financial year ended 30 June For IDB, figures are from financial year 1421H ended 25 April All other banks' financial years end on 31 December Source: Banks financial statements and Fitch 13