Understanding the impact of ‘directed lending’
The Sustainable Development Goals will not be achieved without broad-based economic growth. And this, in turn, cannot be achieved without financial institutions that facilitate payments, provide savers with somewhere safe to keep their money and direct capital to the enterprises that need it.
That’s why investing in financial institutions is important to CDC, and development finance institutions more generally.
One way of targeting investment to the businesses that need it the most is through an approach known as ‘directed lending’. It’s an approach increasingly used by development finance institutions (DFIs) in recent years and involves lending to financial institutions so that they lend to specific types of customer. This might include small and medium-sized enterprises (SMEs), as well businesses with a focus on energy efficiency, renewable energy or that are women-owned.
It is achieved by providing funding to a local financial institution so they then in turn lend to eligible projects or customers. At times it also involves building capacity within the financial institution so that it can provide the finance required by the target projects or customers.
In other words, it’s an important way of getting finance to projects or customers with high development impact.
One of the key advantages of partnering with local financial institutions is that it enables DFI investors to finance businesses that are too small for them to fund directly. The financial institution provides a deal pipeline through its branch network, access to local currency funding and account management of these SMEs.
And if the programme is well structured, the intention is that even when the programme and its incentives come to an end, the local financial institution continues to finance the target businesses on a fully commercial basis.
However, there are some challenges that come with the approach. DFIs need to make sure that they select the right financial institutions to partner with to ensure the funding gets to the businesses they want it to. And because it’s an ‘intermediated’ approach, with an additional layer involved, monitoring and measuring impact needs some careful thought and consideration.
That’s why we’ve published a new report ‘Directed lending: Current practices and challenges’, to clarify and summarise the main approaches used by DFIs to ensure finance is directed to the intended borrowers, and to achieve the required development impact.
One area that the report looks at is the key ‘building blocks’ of a good ‘directed lending’ investment. While the core component is a clause that defines the intended development impact, most go beyond this.
For example, many include technical assistance to help a financial institution build its capacity to enter new markets or expand existing lending. Others include tools such as financial incentives for the financial institution receiving the loan, as well as financial incentives for the businesses who are the ultimate borrowers.
The report also focuses on how to best select the right financial institution to partner with. That includes the importance of the institution having a strategic commitment to the target group of customers and being able to demonstrate capability to effectively manage and report on the portfolio of businesses.
And it also looks at how best to monitor and measure the development impact of a directed lending facility. This involves combining usual reporting requirements for financial institution investees with measuring specific performance indicators, including information that might need to be collected from the businesses borrowing from the facility.
While directed lending is increasingly being used by DFIs, it also has the potential as an approach to mobilise more private sector funding to the regions where we invest. And as an approach that began with a focus on getting capital to SMEs, it’s now being applied to a wider range of themes, including gender and climate change. All of which means it’s likely to attract increased interest and scrutiny.
We therefore hope this research is a helpful contribution – to guide and improve the way this important tool can achieve its intended impact.