22 March 2009
The Inter-American Development Bank should not receive public funding unless it becomes fully accountable to member governments and the public.
Trust has collapsed in most U.S. and many European financial giants, as well as in the cohort of ratings agencies, insurers and business media cheerleaders. The appalling and now predictable sequence of unaccountability begins with hubris and indifference, then shifts to excessive optimism, falling back on denial, then collapse, cover-up and an unapologetic plea for government bailout. From Lehman to Citibank, from AIG to General Electric, financial moguls have used false public statements to stem the flood of exposure of their gross mismanagement and corruption. Each episode of unaccountability carves away a layer of confidence in financial elites that have accumulated massive wealth over the past two decades. Unable to restore public confidence, each day brings a new low in the public trust for corrupt and incompetent financial managers.
Belatedly, the Inter-American Development Bank (IDB) has announced an interest in the issue of trust. Jolted from the deep disconnect with persistent, exaggerated inequality (or preparing to do damage control), the Bank declared it would move beyond macro-economic indicators to study how people actually feel about development and the institutions designed to deliver it. In a recent study on perceptions about the quality of life in Latin America, the IDB tries to reconcile somewhat inconsistent objective and subjective indicators of development. What the IDB has finally stumbled upon is the now well-known pattern of persistently low levels of trust, optimism and quality of life satisfaction expressed by the vast majority of Latin America. Paradoxically for the Bank, trust and optimism are lowest among in some countries that have most loyally adopted IDB policy advice.
Had the IDB enough courage to survey Latin Americans about trust in its own institution, the results would also undoubtedly fit this pattern of distrust, raising painful questions about the Bank’s long-term relevance. Triggered by an internal Bank leak, recent disclosure of massive IDB losses by President Moreno underscore that this distrust is more warranted than ever. The liquid investment portfolio of the IDB has experienced over US$1.9 billion in portfolio losses in the past 18 months. This financial fiasco is all the more troubling in that losses were 10 to 100 times higher than other multilateral development banks (MDB). The IDB will lose money overall in 2008 and have $6 billion less liquidity to lend at a moment of dire need for investment in the region according to U.S. Treasury sources tracking the MDB losses.
Documents
Read the full internal IDB evaluation (Nov. 2008) on the Bank's portfolio losses (PDF, 14,526KB)
Read the IDB July 2008 Board Meeting Minutes where the Portfolio Losses were discussed (PDF, 4,410KB)
Read Senator Richard Lugar's first letter to Preident Moreno (Feb. 5, 2009) requesting explanation for the IDB losses (PDF, 87KB)
Read the IDB reponse to Sen. Lugar's first letter (PDF, 1,114KB)
Read Senator Richard Lugar's second letter to Preident Moreno (Feb. 20, 2009) requesting explanation for the IDB losses (PDF, 315KB
IDB Management Explanation of Portfolio Losses to Board (Jan. 2009) (PDF, 51KB)
Other IDB documents prepared in recent weeks to respond to:
The main source of these losses is the IDB's exposure to “toxic” securities (mortgage backed securities) that grew to approximately 60% of the portfolio during the last decade. Other MDBs purchased similar securities. However, their portfolios had significantly less concentration in these instruments and thus losses were much lower than at the IDB. Figure 6 (from the leaked IDB-OVE report) shows the changing composition of the portfolio over the last decade. Despite claims by President Moreno that no investments violated the Bank’s investment policy, the IDB’s steady purchase of what are now considered extremely risky securities revealed that independent risk evaluation was as a bad or worse as many troubled private banks.
An internal evaluation leaked by the evaluators provides a glimpse at the warning signs for greater problems ahead. Even as the writing was on the wall about the housing bubble, the IDB continued to purchase toxic assets. The OVE evaluation points to “unacknowledged internal incentives to reach for yield” as a key motive for investment decisions that are unusually risky for a public development bank. For example:
- In October, 2007, seven months after hiring Executive Vice-President and former managing director as JP Morgan, Dan Zelikow, for whom responsibility for risk management rested, the Bank invested in two Countrywide MBSs (HELOCs), taking Countrywide's origination risk after its shares had fallen over 50% in response to concerns over its financial stability.
- The Bank holds some securities backed by Mexican residential mortgages at the same time that the Bank was negotiating emergency lending to help Mexico address liquidity needs deriving in part from losses associated with mortgage banking exposure. These securities would seem to in a clear conflict of interest with a liquidity portfolio intended to be uncorrelated with Latin America to avoid double exposure.
- The IDB management also ignored warnings from its own auditor and several Board members demonstrated a clear breakdown in policy enforcement capacity. In the examination of monitoring and reporting a 2005 finding from the Bank's Office of the Auditor General (AUG) was found, which registered concern regarding the significant concentration of ABS and MBS investments in the portfolio and called for remedial actions. Despite repeated mentions of this warning, no action was taken.
The OVE report blames both Board and Management for the lack of oversight and resulting losses – indicators of a relatively weak policy environment and an inadequate risk management culture.
Repeated requests for answers from Senator Richard Lugar of the U.S. Senate Foreign Relations Committee have failed to produce the clear and accountable answers. In two separate letters, the minority chair of the Committee with oversight over the multilateral development banks, has expressed concern not only about the investment losses, but also about the lack of forthrightness in how the issue was made public.
Full Disclosure or Damage Control
Marcus Stern of ProPublica first reported on the IDB losses on Feb. 12, 2008, although the U.S. Treasury has apparently been monitoring the issue across all MDBs for the past 18 months. The report by ProPublica and subsequent conversations with Congressional offices verified that the IDB had not intended for the matter to be made public and was conducting private conversations exclusively with the U.S. Treasury. When faced with questions alleging an accountability problem at the Bank, IDB management shifting into damage control mode. Bank Executive Vice-President, Daniel Zelikow and Chief Financial Officer, Ed Bartholomew, visited Capitol Hill to assuage concerns.
According to sources close to the exchange, the IDB management visit to the Hill and written response by President Moreno failed to satisfy Congressional leaders charged with oversight of the IDB and other multilateral banks. Thus, Senator Lugar was compelled to reiterate several questions regarding IDB accountability and extended the list of questions in a second letter (Feb. 20). The IDB has yet to respond to this second letter, but growing concern among international finance experts suggest how badly the Bank has handled the disclosure of financial management errors.
On Friday Mar. 13, Propublica received a letter from IDB’s External Relations Advisor, Guillermo Miranda, claiming that the copy of the internal IDB evaluation that had been posted was in fact "a forgery" and had been "altered and edited outside the Bank". A second IDB missive to ProPublica arrived on Mar. 16 repeating the allegation of "forgery." ProPublica requested evidence of these two assertions, but have yet to receive any. A Mar. 19 article by Stern in ProPublica upholds the veracity of the original report and the documentation upon which it was based.
In a context where the credibility of financial leaders has evaporated, the IDB finds little sympathy for a defensive and filtered communication strategy about the matter. The remaining unanswered questions include:
- Why the U.S. Congress and public learned of the IDB's losses only after a leak rather than an intentional and full disclosure?
- How did the IDB permit losses on a scale of a "hedge fund," or 20 to 100 times that of any other multilateral development bank?
- Was an auditor general's 2005 report warning against investment risk ignored on multiple occasions?
- Did anyone in Management or the Board speak or act in opposition to the IDB's high risk portfolio investment strategy?
- Why was the IDB purchasing "toxic assets" as late as July 2007 even after a new risk management unit had been created and the value of these assets had declined dramatically?
- How was the Bank's internal incentive structure (bonuses) involved in the portfolio manager's "reach for yield" ?
- What detailed remedial actions were taken or will be taken to ensure that portfolio risk is properly managed?
Why an IDB Replenishment is Unacceptable
Had the Bank’s economists taken up research on popular attitudes earlier, they might understand why news of the financial debacle and lost liguidity doesn’t rally many supporters besides cash strapped Finance Ministers to its recent request for a replenishment from donor countries. Many civil society organizations long familiar with the Bank’s lack of transparency or accountability may find reason to celebrate that a Bank still unable to manage its financial risk has less money to lose.
There may be no less awkward or inappropriate moment to be asking for more public funding, yet the IDB has signaled to its Board and Donor countries that it will request additional capital funds as early as 2010. There are at least four fundamental reasons why a replenishment request should be ignored:
1. The IDB has avoided full accountability for how it fumbled away nearly $2 billion in portfolio investments, when other multilateral development banks were somehow able to avoid such unnecessary risk. Having relied on leaks and public pressure for the partial account that we know, full disclosure would require an independent, external audit that thoroughly reviews the incentive structure and oversight system going back to the last financial crisis when the Bank started loading up on mortgage backed securities.
Any future capital infusions should be subject to equivalent "stress tests" for the multilateral institutions by external regulators to ensure that the IDB has have sufficient capital buffers and regulatory controls to withstand the impacts of an uncertain economic environment. Such a stress test would analyze "potential firm-wide losses, including in its loan and securities portfolios, as well as from any off-balance sheet commitments and contingent liabilities/exposures, under two defined economic scenarios over a two year time horizon (2009 – 2010)." This would include estimates of potential trading-related losses under these same scenarios. Forecasts of internal resources available or needed to absorb losses and extend new lending in the region (such as the assessment presumably under preparation by the high-level Kuchinski commission), should be vetted with public oversight commissions.
2. The IDB has avoided full accountability for a mismanaged, expensive and ineffective realignment. The roots of the IDB portfolio losses start prior to the election of Luis Alberto Moreno as Bank President in 2005. However, strengthened risk management was declared a goal of the massive, expensive realignment that Moreno initiated in 2006. Along with many other lofty goals, risk management failed to be strengthened.
The OVE evaluation concludes, “These [risk management] functions remain underdeveloped in part for a lack of Management willingness to allocate required resources. Repeated requests for budget and staff increases for the risk management function have not been granted by Senior Management and contrast sharply with noticeable increases in resources allocated to the external relations function.”
As a public development bank, the IDB gives the impression that accountability to member governments and the public regarding recent portfolio losses is about minimal disclosure and damage control rather than rebuilding institutional credibility.
3. As many regional organizations gathering in Medellin and others claim, the IDB remains unaccountable in terms of its management of development risk. Persistent poverty and inequality after fifty years of lending in Latin America call not for celebration but for serious, critical evaluation of the effectiveness of the IDB as the primary source of multilateral finance. Still, the official Bank program of events and comments by President Moreno indicate that the Bank wants to look forward, rather than back on its 50th anniversary. Including the results of the recent Bank realignment, a full accountabilty of the development risk of future lending by the IDB is required (qualified by development performance rather than capacity to repay debt)
4. The IDB is not viewed as a true development partner by a growing number of Latin American borrowing countries after decades of failed policy advice, ineffective operations and inadequate responsiveness to client demands. Recently increased demand for IDB loans is an exception to a five year period (2002-2006) during which the IDB struggled to find borrowers. The IDB is viewed as a "lesser evil" among MDBs and carries less of a stigma among critics of MDB finance than the IMF. The IMF, which remains unwelcome among most Latin American finance ministers found no takers for a recent IMF emergency lending window of $100 billion announced in Oct. 2008. However, the IDB is exercising the same conditionality of the IMF in screening borrowers for its own emergency lending. Nicaragua was rejected for IDB emergency finance due to the lack of a standing IMF program. Donor treasuries should be skeptical of the IDB's capital replenishment request for which its own institutional credibility may represent a significant obstacle in its effective use.
Short of meeting any of these and perhaps other conditions, the IDB has no business damaging the public trust further by requesting more public money.