Development banks - UK in a changing Europe (2024)

DATE

14 Sep 2023

AUTHORS

THEME

Economy

Policies

Stephen Hunsaker and Peter Jurkovic explain what development banks are, including their key features and functions and role in supporting the transition to net zero.

For more on development banks, you can find our new report on UK development banks post-Brexit here.

What is the role of development banks?

A development bank (also referred to as a state or public investment bank) is a majority public-owned entity that seeks to achieve certain socio-economic goals in a specific region or economic sector through the use of repayable financial instruments. They focus on long-term low-interest financing instead of profit-driven higher-interest-rate lending as is done by private investment banks.

They include both multilateral development banks (MDBs) which operate across multiple nation-states, such as the World Bank and the African Development Bank, which are co-owned by their member nations and national development banks which concentrate on work within the boundaries of a single nation-state, such as Kreditanstalt für Wiederaufbau (KfW) in Germany.

What are the key features of development banks?

Development banks have key features that differentiate them from private commercial banks:

Patient finance:

While private lenders and commercial banks primarily aim to generate profits for themselves or their shareholders. Development banks tend to be owned by the state, and are, therefore, directed to achieve a range of socio-economic goals rather than to solely make high returns.

This allows these banks to provide what is called ‘patient financing’ – long-term financing without the obligation of high returns in the short term. This kind of financing is important for many social and environmental projects, new technologies, start-ups, and other investments deemed too risky for the private sector.

Cheaper lending:

Because they are state-owned (or co-owned by multiple states in the case of multilateral development banks) these banks are very unlikely to default, and therefore, tend to have much higher credit ratings. This allows them to borrow cheaply on capital markets and, therefore, offer cheaper lending than most private lenders.

For example, multilateral development banks (MDBs) benefit from Preferred Creditor Status (PCS) which means that sovereign borrowers will continue to service their loans from MDBs even if they default on their other claims.

Similarly, many national development banks, such as KfW, have the same credit rating as the state in which they operate.

Longer-term perspective:

Although state-owned, these banks are usually independent from direct government control. As a result, they are insulated from political interference and short-term political preferences, allowing them to pursue longer-term objectives.

What are the key functions of development banks?

Many modern state investment banks were established when the Marshall Plan was rolled out to help reconstruct Europe after the destruction of World War II in 1948. These banks were designed to, first, promote financial stability through a flow of patient finance to fund post-war reconstruction. And, second, to avoid the possible destabilising effects of speculative private finance on economic recovery, in particular through providing a counter-cyclical role — increasing investment and lending when the overall economy is slowing down and when private banks are cutting back on lending.

They can now be seen to offer some particular key functions:

Additionality:

One of the main ways that development banks measure their impact is through the ‘additionality’ they deliver. If a project would not happen without funding from a development bank, then the bank can consider its involvement as providing ‘additionality’.

“Development banks have increasingly taken on the role of supporting innovative firms and start-ups”

As a result, development banks often have mandates or targets to invest in the sectors of the economy or the types of innovative projects that the private sector is less willing to invest in.

More recently, development banks have increasingly taken on the role of supporting innovative firms and start-ups. Early-stage innovation often requires high up-front costs and long-term finance without a guarantee of returns, let alone in the short term. As a result, these can be less appealing projects for the private sector, leaving a gap for development banks to step in to offer the patient strategic finance required for innovation. Indeed, it has been pointed out that throughout much of the world, public sector actors are leading investment in the early stages of the innovation chain.

Crowding-in:

Development banks try to incentivise the private sector to co-fund these projects and, therefore, achieve their goal of ‘crowding-in’ – mobilising investment from the private sector into projects.

The main way they achieve this is through reducing the risk profile of certain projects in order to attract private finance and investment.

For example, development banks may take on ‘junior’ debt, where they are the first to absorb potential losses, and allow private sector co-lenders to hold more senior debt. This reduces the risk for private lenders and, therefore, makes investments more attractive to them.

Both additionality and ‘crowding in’ have been endorsed by the heads of MDBs as shared principles since 2012.

Expertise:

Development banks have a great degree of in-house expertise in particular sectors of the economy, science and engineering, as well as financial expertise more generally. This also helps them to crowd-in private sector investment.

First, development banks can play a ‘first mover’ or catalytic role. That is to say, when they are the first to finance a particular kind of project or business, the private sector has the confidence to follow their lead because it recognises the extensive research teams and industry expertise of development banks.

Second, development banks can use their expertise to provide less experienced project developers with technical assistance and to help them to meet the due diligence requirements necessary to attract finance from the private sector. They can also help to draw in private sector finance by educating and informing investors about emerging industries and what risks are associated with them.

Are development banks independent?

Another benefit of these banks is their separation from government control. While development banks tend to be majority public owned, their governance is usually independent of the government.

Most development banks have a Board of Governors, usually filled by political representatives (either government ministers or government appointees), which tends to have ultimate-decision making authority and determines the overarching principles and strategic decisions of the bank. However, most of these banks also have a separate executive management team which is responsible for the day-to-day operation of the institution and makes decisions on projects that the bank will finance.

This arrangement allows those running the banks’ operations to be insulated from political interference and shorter-term political pressures to create longer-term objectives. This also gives the private sector confidence that projects are being chosen according to the overarching mandate of the bank and according to the best banking principles rather than due to political pressure.

What is the role of development banks in the transition to net zero?

Development banks can provide green finance in a way that the private sector cannot, and this can be crucial to developing many of the technologies necessary to achieve net zero.

In order for the world to meet its climate targets, as set out in the Paris Agreement, there needs to be a significant increase in global investment into the energy transition. According to some reports this will require annual investments to more than quadruple so that global investment in transforming infrastructure reaches USD 6.9tn each year.

“Development banks can provide green finance in a way that the private sector cannot”

The Climate Change Committee (CCC) has estimated that the UK alone will need to scale up its investment in net zero technologies from £10 billion a year in 2020 to £50 billion a year by 2030. As a result, the state and public finance can play an important part in ensuring that the necessary finance is mobilised and directed into green projects.

A particular issue with leaving the private sector to channel finance into green projects without any direction is that many of the low-carbon technologies and efficiency measures, which states need to rapidly deploy to meet net zero goals, are, for a variety of reasons, unappealing investments to the private sector.

For example, many of the important areas of investment needed to achieve net zero are into new technologies or businesses with unique models that have little track record, which private investors or debt providers tend to be uneasy about investing or lending to.

Many of these also require large upfront capital costs with long-term time frames for returns, which tend to not be very appealing investments for private investors.

Finally, there is considerable uncertainty in the low-carbon sector due to frequent technological innovation and shifting government policy on climate targets. Therefore, there is concern among private investors that they could invest in technology that may soon become outdated or regulated against.

This is why development banks can play a crucial role. On account of their design features described above (ability to borrow cheaply, less pressure to generate short-term returns etc.), they tend to be more willing and capable of offering the patient, long-term financing for these higher-risk investments.

In addition, they can play a de-risking role or help to provide technical assistance for specific projects, which can help to mobilise private investment.

KfW in Germany, Clean Energy Finance Corporation (CEFC) in Australia, and the Brazilian Development Bank (BNDES) in Brazil are all examples of development banks that have helped to channel a significant amount of finance to green technologies.

Are there any development banks operating in the UK?

Until recently, the main development bank operating in the UK was the European Investment Bank (EIB). The UK joined the EIB in 1973 and since then, it has been the UK’s primary domestically-focused development bank, supporting infrastructure projects, innovation, and small and medium-sized enterprises (SMEs). However, following the UK’s withdrawal from the European Union in 2020, the UK lost access to EIB finance.

It has helped to finance some of its biggest projects, ranging from the Channel Tunnel to the second Severn crossing, to the Thames Tideway Tunnel, the Manchester Metrolink extension, and London Underground upgrades.

From 2009 to the end of 2016, the EIB lent on average £6.4 billion annually in real terms within the UK – reaching a peak in 2016 at £7.5 billion.

Since the Brexit referendum, the UK has tried to replace the EIB in its development finance eco-system.

The UK government has since created three new development banks. The Development Bank of Wales (Banc) was established in 2017, followed by the Scottish National Investment Bank (SNIB) in 2020, and, lastly, the UK Infrastructure Bank (UKIB) in 2021.

Two other development banks were already operating in the UK. The GIB was established in 2012 by the Conservative-Liberal Democrat Coalition government with the aim of accelerating the country’s transition to a low-carbon economy. But in 2017, the GIB was sold to a consortium led by the Macquarie Group Ltd.

The UK’s SME-focused bank, the British Business Bank (BBB), was established in 2014 before the referendum. Since then, it has received an increased level of funding from the government in order to replace investment from the European Investment Fund (EIF), the SME arm of the EIB.

When all four of the UK’s currently operating development banks are taken into account, £2.4 billion was invested in 2022 – the highest figure since losing access to EIB investment. This represents less than half of the EIB annual average from 2009 to 2016 and 32% of the 2016 peak.

By Stephen Hunsaker and Peter Jurkovic, researchers, UK in a Changing Europe.