This op-ed was originally published in Next Billion.
After hitting a 10-year low in financing flows in 2022, Convergence data shows that blended finance bounced back to a five-year high of $15 billion in 2023. Helped in part by multilateral development banks and development finance institutions investing in greater sums in 2023, several large-scale blended transactions came to market in close succession over the course of that year. One of these “whales” was the SDG Loan Fund, a $1.11 billion investment vehicle, devised by Allianz Global Investors and the Dutch Entrepreneurial Development Bank and backed by the John D. and Catherine T. MacArthur Foundation, that looks to draw more institutional investors to climate, agriculture and financial services investments in emerging markets.
Despite this positive turn, several foundational questions facing blended finance remain unanswered. For instance, how can donor governments worldwide develop and adopt a coherent private sector mobilization strategy to tackle the SDG financing gap, one result of which would be greater support for blended finance? How can developing country governments play a bigger part in this process as donors, while helping to catalyze domestic institutional capital that remains largely untapped when it comes to financing SDG investments? How can more standardized and simplified vehicles be developed to appeal to private sector investors? And how can greater transparency on blended finance transactions be encouraged?
These pivotal questions presuppose that highly regulated financial institutions like commercial banks and insurance companies can be seamlessly mobilized for development projects in emerging markets and developing economies (EMDEs). But they overlook a critical obstacle: the complex web of policies and regulations governing these institutions that deter them from investing or lending in EMDEs.
As blended finance looks to build upon its renewed momentum, it becomes more essential for the industry to address and overcome the regulatory roadblocks that hinder its ability to scale. Below, I’ll discuss these obstacles and some promising solutions, as outlined in Convergence’s State of Blended Finance 2024 report.
Understanding the regulatory roadblocks to private investment in EMDEs
There are several common regulatory roadblocks that make it difficult for private financial institutions and investors to invest or lend in EMDEs. Firstly, the mandates of many investors limit their ability to invest in developing economies. The median sovereign risk rating in the 142 EMDEs is “B-”, which is considered sub-investment grade, so most developing countries do not align with the criteria of many investors. Additionally, highly-regulated financial institutions like commercial banks and insurance companies are required by international standard setters to hold more capital in reserve for riskier assets. In some cases, these institutions must cap the investment amounts held in certain types of assets (particularly those below investment grade). This poses a challenge to investing in the developing market assets supported by blended finance, many of which lack official rating methodologies and thus assume the credit rating of the country in which they’re domiciled (i.e., the sovereign ceiling).
Secondly, under the Basel IV international banking reforms, standardized metrics have replaced the proprietary models formerly used by commercial banks when weighting their financial assets by their level of risk, to determine the amount of regulatory capital they must hold in reserve. This means that commercial banks may no longer be able to lower their risk-weighted assets (and the amount of regulatory capital they must hold in reserve) by independently rating an investment in the senior tranche of a blended finance vehicle as lower risk, to reflect the protection they receive from investors in the first-loss tranche who bear the initial losses on the fund’s investments. Commercial banks are typically only willing to make senior tranche investments, so without this rating flexibility, they may be further disincentivized from investing in blended finance vehicles as a stepping stone to investing in EMDE transactions with acceptable risk/return ratios.
Further, international regulators lack adequate access to accurate information on default and recovery rates in developing markets. This means that the ratings given to projects and institutions domiciled in developing markets (which support the risk weightings commercial banks use to calculate their regulatory capital requirements) may not accurately reflect the reality of investing in these markets.
Convergence’s State of Blended Finance 2024 report represents the first time we’ve explored these issues in detail. In the report, we analyze some of the key regulations affecting whether and how private sector investors can structure and/or invest in blended finance vehicles as a means to increase their ability to participate and invest in EMDEs more broadly. This analysis dovetails with reports published by other organizations, with one study from the Global Alliance of Impact Lawyers, for example, also discussing the legal and regulatory barriers to blended finance, and another paper from the Overseas Development Institute exploring how changes across Europe in national and EU investment regulations and financial market conditions might impact the contribution of European pension funds and insurance companies toward the investment needs of EMDEs.
Three ways to address the regulatory hurdles facing private investment in EMDEs
Given the impact these regulatory hurdles have on blended finance’s mobilization potential, what concrete steps can be taken to address them? We’ve identified three key action points:
Firstly, practitioners should adopt a multi-stakeholder approach to building mutual understanding on blended finance across the blended finance and regulatory communities. To that end, they should create a formal framework that provides policymakers and regulators with a starting point on how to approach blended finance, while also establishing multi-stakeholder platforms to encourage dialogue. Regulators need to be consulted early in blended transactions, and they must become more educated on the practice and scope of blended finance through indicative case studies of what worked and didn’t work. Ultimately, they must also coordinate with each other where necessary to address common barriers and obstacles, while protecting the integrity of the financial system. In so doing, supervisors should explore ways that their regulatory systems can be updated to cater to innovative finance, specifically blended finance.
The creation of domestic multi-stakeholder platforms encouraging dialogue and the sharing of learnings between the public, private and regulatory communities can help advance these efforts. One example of this kind of platform is the Joint Committee on Climate Change, established in 2019, which is a regulator-industry platform working collaboratively to build climate resilience within the Malaysian financial sector. These platforms should also have a dedicated dialogue on blended finance, to encourage momentum on bringing diverse stakeholders together in areas where the need for more blended activity has been recognized.
Secondly, supranational forums like the G7 or G20 should be used as the space for a policy dialogue between donors and regulators on capital allocation rules for blended finance, with donors and institutional investors partnering to better calibrate concessional tools to existing regulations. Supranational forums should facilitate peer-to-peer learning between countries on the experience and practice of blended finance through a formal knowledge exchange within their working groups on sustainable finance. Any learnings from these efforts can inform the forums’ policy decisions on any regulatory issues related to blended finance, and can ultimately feed through to standard setting bodies.
Finally, practitioners should prioritize data transparency, to showcase the actual risk of investing in developing markets to regulators and institutional investors. Development finance institutions and multilateral development banks could support the mobilization of private investors by sharing the payment track records of their portfolios more extensively. Such data is consolidated in the database maintained by the Global Emerging Markets (GEMs) Risk Database Consortium, and its release would illustrate that well-structured project finance in developing economies is not as risky as regulators and investors may assume. A first step was taken toward providing this information in March 2024, with the publication of a GEMS report showcasing aggregate data on the recovery rates of investments with private and sub-sovereign borrowers in EMDEs. However, the report does not give the level of granularity that rating agencies or private investors need to inform their models and revise current capital allocation rules. With access to a more comprehensive data set, rating agencies could be more actively involved in rating blended funds and instruments to better reflect the credit enhancement benefits from first loss and/or junior tranche investors. This could enable regulators to consider reducing the risk weights for senior investor positions in structures protected by first loss, thereby helping to draw more large institutional investors into the market.
With the market for blended finance rebounding, and the urgency of scaling financing toward the SDGs only heightening as we approach 2030, practitioners must get creative in understanding the roadblocks that private investors face when investing in developing markets — and finding new ways to address them. The measures discussed above would go a long way toward creating an environment where large private investors can ramp up their involvement in blended finance, and in the markets where this capital is most needed.
