There are six main imperatives for DFIs across the region to take their role to the next level and deliver on their dual priorities:
1. Embracing the ecosystem
DFIs can optimally succeed in delivering their mandate if they partner with their surrounding ecosystem. In the GCC, the ecosystem is filled with players that have successfully built digitally advanced front office and back office capabilities that would enable DFIs to deliver leaner operating models, broader reach, and improved customer experiences.
For instance, banks have long been evolving their digital back office capabilities allowing for faster and more personalized engagement with customers and regulators. DFIs have to double-down on their digitization efforts and, more importantly, their integration with ecosystem players, which should complement a transparent interaction model and governance framework. Such a model should also encompass FinTechs, providing an opportunity for DFIs to collaborate with them and benefit from their disruptive solutions, especially those focused on small- and micro-financing.
Also, there is a potential opportunity for DFIs to realize synergies by sharing some standard functions and infrastructure. For instance, creating a common shared services utility to support such entities could serve to liberate bandwidth from DFIs which can be redirected at serving targeted companies and tailoring solutions to their needs.
2. Reinforcing social impact measurement
An overall framework must be introduced that allows recipients to report on their progress and impact, using harmonized templates that are then consolidated and analyzed by artificial intelligence (AI) capabilities to measure the actual effect of the financed projects, bringing a data-driven overview on the economic impact of the funding.
Granular analysis of specific sectors can be attained. For example, the World Bank estimates that every dollar invested into climate-resilient infrastructure averages a four-dollar return that safeguards productivity gains and job creation infrastructure supports.
Metrics can also be measured using talent and data analytics to gauge who DFI fund recipient companies are hiring. For example, the granular nature of data can be used to ascertain how well companies are doing in driving diversity or impact. According to a recent UN report, achieving gender equality would unleash tremendous economic gains, potentially adding US$17 trillion to global GDP by 2025. If DFIs can leverage the right platforms like these, they can quickly include diversity and inclusion metrics in DFI contracts.
3. Adopting digital platforms for local content access
There has been a rise in local content development policies that can convert the government spend and the subsidized funding to the private sector into potential economic growth and job creation.
To ensure that the private sector recipients of funding search for and procure local talent, services, manufacturing, and production for the digital platforms, new tailored solutions must be introduced where domestic options are made available - and developers should be provided with a breakdown comparison vs. the cost of importing that same category.
In the current era, procurement technologies can now bake-in such metrics with Artificial Intelligence - which means that DFI fund recipients can produce reports proving that they have assessed and – when applicable – sought local companies’ products and services. Beneficiaries must then provide audited statements on the usage of funds and the impact created whilst governments measure the sector’s actual performance.
From the initial purchase request to approvals, sourcing and payment can drive purchasing managers to assess and – where applicable – prioritize local vendors and make informed decisions. This means that DFI support recipients can use such platforms to prove to the authorities that they have systems in place to deliver on their core promise – to enrich domestic value chains wherever applicable. Procurement platforms can also ‘bake-in’ recruitment of locals, mandating that talent vendors prioritize locals over expats.
4. Introducing advanced technology programs
DFIs can accelerate the adoption of new and emerging technologies across industries, including traditional sectors, and contribute to the national digital and innovation agenda. To do so, they have to introduce tailored propositions per sector, which should typically include the financing component and the vital job of educating stakeholders on the benefits that advanced technologies bring to the businesses.
Very significantly, such a proposition goes together with other nationwide initiatives and should aim at connecting the emergence of local suppliers of advanced technologies with beneficiaries through these tailored propositions.
Creating an enabling innovation ecosystem for local manufacturers, SMEs and entrepreneurs is also a second route to helping DFI capital recipients meet their obligations. Around the region, we have seen innovation hubs, enterprise programs and unique funding models for SMEs.
There is also a job for policymakers to drive local vendors and home-grown industries toward companies that have received DFI funds. This is where GCC governments have proven to excel. The innovation ecosystems of countries across the Gulf have become exceptionally active over recent years, particularly in telecommunications and FinTech. And, it is in the realm of financial services that governments can achieve strong outcomes.
5. Adopting financial services practices
As DFIs increase their integration with the financial services sector, it becomes imperative to adopt common practices relating to compliance and credit, and risk management.
Many of the issues commonly recognized to afflict DFIs are associated with, if not attributed directly to, weaknesses in governance and compliance. Government-owned development funds and institutions, which have public policy mandates, present further governance challenges, notably concerning managing the trade-offs inherent in conflicting modes of operation. This includes offering subsidized finance to specific customers while adhering to commercial business practices and maintaining financial sustainability.
Some other examples include:
- Lack of transparency when government officials directly intervene in day-to-day operational decisions, such as credit approval, granting, waivers and write-offs
- When executive management intervenes in contracts, contrary to sound commercial business and public financial management principles
- Board members lack the independence, professional skills, and experience necessary to discharge their responsibilities properly
- When internal and external financial and nonfinancial reporting is incomplete or inaccurate
The issues highlighted above may result in loss-making, inefficient and/or ineffective DFIs’ operations, and a weakened financial system. Inadequate governance can also lead DFIs to underprice risks and otherwise engage in business practices that displace the provision of commercial, financial services by the private sector. This risk impedes new private entry and undermines competition.
Good governance can help to ensure that DFIs are managed within a clear vision of how they will overcome existing weaknesses or problems in the provision of the needed financial services without becoming part of the problem themselves. It can ensure that DFIs pursue the objectives for which they were established, preventing deviation from their primary goals and an institutional tendency to continue to grow in size and expand in scope. Good governance also serves to increase stakeholders and business partners’ confidence and lower DFIs’ costs – saving precious public funds. It also improves the state’s ability to attract private capital for eventual ownership diversification, and perhaps even privatization.
With a clear definition of policy mandates and agreement on the means to finance them, it is easier to agree on specific policy, financial and operational performance targets with the board and executive management of a DFI.
- Policy targets give more detailed specification to the policy mandate. These should be expressed in quantifiable, measurable terms, including development outcomes.
- Financial targets seek to ensure that the management and board assure long-term economic sustainability without potential resort to extraordinary government support.
- Operational targets, in effect, seek to ensure that compensation for policy activities is passed on to users of financial services or other clients and is not absorbed by inefficient operations (high costs) or other losses.
6. Embedding sustainable finance principles
Sustainable finance is typically defined as any form of financial service that incentivizes integration of long-term environmental, social and governance (ESG) criteria into business decisions to provide more equitable, sustainable, and inclusive benefit for clients and society.
As such, DFIs have a crucial role to play in the transition to a sustainable global society that aligns with the UN’s 17 Sustainable Development Goals (SDGs). The SDGs are increasingly becoming an essential framework around which financial services are organizing themselves.
Sustainable finance will profoundly affect the operating models of DFIs, with environmental and climate change matters representing a critical emerging risk over the medium term. The nature of climate risk is such that it affects portfolio management, risk management, pricing, underwriting, and eventually the overall profitability of firms. However, the story is not all that pessimistic if DFIs and regulators take an active approach to tackling the problem. Climate change presents an ocean of opportunities to induce innovative strategy and analytics to develop refined products and services to boost financial prosperity. The marriage of enhancing risk mitigation capabilities and bolstering sustainable finance competence will ensure that DFIs cater to the vast impacts while warranting long-term prosperity. DFIs are empowered by the responsibility they hold in actioning sustainable finance principles to achieve goals of economic prosperity, social inclusion, and environmental regeneration.
Credit and risk management also dovetails with integrating long-term ESG criteria into business decisions to provide more equitable, sustainable, and inclusive benefit for clients and society. Climate change risk is specific, having a direct impact on the DFIs and the clients they serve. It can be broadly categorized under two types:
- Physical risk refers to the direct impact of changing weather patterns in seasonal extreme weather events and chronic circumstances like heatwaves and rising sea levels.
- Transition risk refers to market, credit, technology, legal, and reputation risks, among others, that may arise when stakeholders begin transitioning to a low-carbon economy.
While the topic of sustainable, ESG-driven finance is rapidly gaining momentum and its regulatory framework is evolving, DFIs must prepare to integrate ESG factors into their risk management framework and consider the following factors:
- Risk governance, strategy and culture: From a DFIs perspective, the impact of climate change is more specific given the risk arising from their business, clients, and the environment in which they operate. As such, a new playbook is required for DFIs to understand and tackle climate change risk, ranging from how it is governed to how it is embedded across the institution’s “three lines of defense”. The governance structures need to focus on actively embedding and driving the management of climate change risk in strategic decision-making, including incorporating climate-related issues in determining risk appetite, strategy, policies, budgets, acquisitions, and divestitures, well as on monitoring and oversight.
- Risk and control framework: From an enterprise risk management standpoint, chief risk officers should look to weave climate change risks into the core framework components, including risk identification, risk assessment – including the indirect impact of climate change risk on other financial risks such as credit and liquidity risk. Also necessary are scenario analyses and the definition of specific stress tests – helping to ascertain the impact of both physical and transition risks on assets, investments, and credit portfolios. In a similar vein, institutions should also evaluate and re-examine their current business continuity and disaster recovery plans to determine readiness to address disruptions to core business operations.
- Sustainable finance reporting and disclosures: There is increasing regulatory scrutiny with climate change disclosures forming part of regulatory requirements. They include the Prudential Regulation Authority’s (PRA) expectation for firms to fully embed their approaches to managing climate-related financial risks by the end of 2021. There is also an expectation that financial regulators in the MENA region will require financial institutions to put in place measure to identify, effort, monitor and report on climate change risks. In June 2020, the Arab Monetary Fund published a set of guiding principles for central banks to address the impact of natural disasters and climate change on the banking system’s stability. This would mean DFIs would need to review their current internal (Board and senior management) and external (regulator, where applicable) reporting mechanisms and supplement these to ensure linkage of climate change risk impact on their current risk framework. These can include credit concentration and investment portfolio limits and thresholds, credit underwriting policies, internal capital adequacy and liquidity risk thresholds, operational risk indicators, and reputational risk and conduct risk management frameworks.
Where do we go from here?
The post-COVID-19 pandemic world presents an exciting moment for DFIs as their role becomes ever more critical for the successful recovery of their respective economies and accelerating their nation’s digital and innovation aspirations.
As vaccination campaigns are rapidly progressing in the GCC, there is a general sense of optimism for sustained economic growth in 2021 and the years ahead. This growth can be solidified and accelerated through the active involvement of DFIs in their sectors and the continuous modernization of their role.
