The World Bank was founded in the aftermath of World War II as a vehicle for transferring investment capital from capital-rich to capital-poor countries. The initial idea was simple, brilliant, and perfectly adapted to the opportunities and constraints of the immediate postwar period. It was to create an institution that would borrow cheaply, backed by the guarantees of the United States and other non-borrowing capital-rich sovereign members, so as to lend at low rates to capital-poor governments. By the mid-1960s, the Inter-American, Asian, and African Development Banks had been set up along the same lines. In the early 1990s, with the end of the Cold War and the entry of the former Communist economies into the market system, came the European Bank for Reconstruction and Development.

But times have changed. The 1990s were not particularly easy on the World Bank and its sister regional banks. The forces of globalization have put them in a squeeze. Globalization has brought a quantum increase in private capital flows to most middle-income countries in Latin America, East Asia, and Eastern Europe and to a few low-income countries such as China and India. That has raised serious questions about the original mission of the multilateral development banks -- transferring investment capital from capital-rich to capital-poor countries. At the same time, government shareholders, often led by the U.S. government, have increased their demands on the banks -- to deal not only with growth and development, but with poverty reduction, debt management, financial crises, post-conflict reconstruction, donor coordination, and the management of global environmental programs. These additional mandates, the increasing cost of "safeguards" such as environmental impact analysis, and a general shift away from large infrastructure investments to smaller, "softer" projects in the social and environmental areas and the rule of law, have raised the cost of doing business and threaten the long-term profitability that large, simpler projects brought. They have also contributed to an apparent loss of focus that has undermined the banks' political support.

Two additional issues in the 1990s were also lightning rods for criticism of the MDBs. In the poorest countries, accumulation of unmanageable debt to the MDBs (along with other official creditors) raised serious questions about the effectiveness of multilateral loans. And MDB participation in financial rescue packages for Mexico in 1995, East Asia in 1997, Russia in 1998, and Brazil in 1999 was heavily criticized. Some argued these rescue packages contributed to moral hazard and bailouts of private creditors; others saw them as kowtowing to U.S. or other major shareholders' narrow interests; while still others viewed them as occasions for unwarranted and unreasonable loan conditionality.

As with democracy (recalling Churchill's famous point), none of the relevant parties (nowadays "stakeholders") has been happy with the performance of the banks in the last decade. But apparently the owners of the banks, the member governments, saw no better institutional alternatives for a growing number of global finance and development tasks.

Then in March 2000 came the report to the U.S. Congress by the International Financial Institution Advisory Commission, better known as the Meltzer Commission, after its chairman Allan H. Meltzer. It recommended that the MDBs withdraw completely from middle-income countries with significant access to private capital (the commission defined "middle income" countries as having per capita incomes over $4,000 or an investment grade sovereign credit rating). It also called for the World Bank to abandon lending altogether to the poorest countries and become a grant-giving World Development "Agency." Those recommendations reflected growing skepticism about the continuing relevance of the original logic of the banks, both for transfer of capital to relatively high-income countries (Korea, Poland, Argentina, Brazil) and for continuing their bank-like functions in the low-income countries. Indeed, as the new Bush administration formulates its approach toward international finance, it is a good time to revisit questions about the multilateral development banks. As the global environment changes, what is, in fact, the rationale for the MDBs' existence? Should they do less or more? If there is a rationale, what changes are needed in their financial and other policies to make them more effective in the changed environment?

DON'T SCRAP THE BANKS

There are good reasons to sustain the MDBs as lending institutions in the developing world. First, the Meltzer Commission's idea to abandon all activity in the middle-income countries is boom-centric. Private capital flows are strongly pro-cyclical, and, despite relatively high incomes, emerging economies are still susceptible to external and internal shocks that trigger rapid reversals of inflows. Today, countries such as Brazil, Mexico, Thailand, and South Africa can borrow from private banks and the global capital market. But when times are tough in world markets, their access to private credit is by no means assured. For those who continue to have access, the costs skyrocket. For this reason Argentina avoided borrowing altogether for much of 1998.

Paul Volcker, former head of the U.S. Federal Reserve System, has characterized emerging market economies as small boats in a turbulent sea. Even with a competent crew and a seaworthy vessel, a big storm can sink a small boat. One sign that an economy is a small boat is the fragility of its hold on an investment grade rating. Colombia lost that rating last summer. Venezuela's investment grade rating of a decade ago disappeared well before its recent political troubles.

Second, even small amounts of MDB lending can be critical to "crowd in" private investment, as long as the economic fundamentals in recipient countries are sound. MDB lending is focused on strengthening the institutional capacity and policy-making tools in developing countries to create an environment that is conducive to increased private investment. Development investments -- in schools, roads, banking supervision, and municipal reform -- help create a positive climate for increased private investment.

MDB financing also provides a signal to the private market of a country's medium-term policy commitment and institutional capacity. This can be important for small economies, where the costs to the private sector of tracking local policy and institutions -- such as in transportation or banking -- is relatively high. For those economies the tacit endorsement MDB lending provides can help attract private capital. Of course it is possible to separate the signaling function from lending, as rating agencies such as Moody's and Standard and Poor's do. But the detailed involvement of the MDBs in preparing the projects they finance means they are seen as having better information than they otherwise would.

Finally, the MDBs can advance the process of reform within countries by helping catalyze a dialogue among different interest groups -- between government and the democratic opposition, between the central and local governments, between civil society and government. The lending process gives them a convening power to bring together actors and to provide a forum for coordination and dispute settlement. Their convening power reflects their being relatively independent brokers with global expertise in what is best practice on a wide range of policy and technical issues.

BUT END "BUSINESS AS USUAL"

This is not to say there is no need for change if MDB financial and other policies are to adapt to changing demands. What changes might make the MDBs more useful and their activities more sustainable and cost-effective in the changing global economy? Here are a few.

Differentiate pricing with an eye on profitability: For all public sector loans, the World Bank and the regional development banks use cooperative pricing. Every borrower faces the same interest costs and, for most part, has the same repayment period (e.g., for the World Bank, usually 15 to 20 years including a four- to five-year grace period). With a more flexible pricing regime, the banks could adapt to the different (and increasingly divergent) needs of countries. MDB pricing could become more situation-, country-, and product-specific. In the medium term, that could enhance the finances of the institutions and reduce their need for increased capital. Higher interest rates for larger, fast-disbursing loans are one example. (In a heretofore exception to the general rule, the World Bank and the Asian Development Bank charged higher interest rates for their 1998 emergency loans to Korea.)

More radical (and controversial) would be a decision to key interest charges to countries' per capita income, for example, charging higher rates to higher-income countries. Note that all rates are subsidized through the guarantees of the non-borrowers against the liabilities of the institutions; the subsidy would be smaller for higher-income countries were they to pay higher but still subsidized rates. Higher rates for higher-income countries would bring MDB rates closer to the market, decreasing any chance that MDB financing would crowd out private investment and encouraging self-graduation as the financial advantage of MDB borrowing to the countries declined. The Meltzer Commission's recommended automatic graduation (at $4,000 per capita income) fails to allow for differences in institutional readiness and for the benefits of MDB dialogue and advice that even higher-income countries might want to exploit -- but should also pay for. Finally, higher pricing would encourage a more efficient, competitive, and client-oriented bureaucracy to sustain adequate demand from these more creditworthy borrowers.

Similarly, lending maturities could be more flexible. Why should countries have to take a 15-year loan if good debt management makes a 10-year loan optimal?

Deal with emergencies: Beginning with Mexico in 1995, the MDBs have been involved in rescue packages in emerging market economies. The Meltzer Commission concluded that the MDBs should not participate in any form of crisis lending and should leave all responsibility to the IMF. Yet the MDBs have played, and should continue to play, an important role in helping countries recover from economic crises. MDB emergency loans were conditioned on internal structural changes in the areas of financial management and social safety nets, and capitalized on the emergencies to establish stronger monitoring and evaluation capabilities and supervisory systems in these countries. Only the most efficient social sub-programs were targeted for funding to support safety nets.

Emergency lending puts a potential strain on the banks' capital resources, however. One option is to charge more for these loans -- as in the Korea example. A second is for the banks to create a contingent lending instrument. That would help prevent emergencies by reassuring private creditors of adequate country liquidity in the event of shock. As lending would (ideally) not actually be triggered, the banks would need to charge countries the equivalent of an insurance premium or guarantee fee to cover the banks' costs of carrying the potential loan on their books.

Don't end, but do fix, conditionality: Critics argue that MDB conditionality has undermined "ownership" of reform. But this frames the argument as one of ownership versus conditionality. In fact, given ownership, which is necessary for reforms to be sustained, conditionality can be complementary. If ownership is there -- by governments that are accountable to their citizens -- then agreements, understandings, and, yes, "conditions" can help governments signal to local and foreign investors their own medium-term commitment to sustaining their reform programs.

But once conditions are agreed, the MDBs must enforce conditions, including via cutoff of disbursements against loans. Lack of enforcement in the past has undermined the banks' effectiveness. In the poorest countries, mostly in sub-Saharan Africa, the result has been a lot of lending and a lot of debt without much in the way of development results. Enforcing conditionality means in the end that lending will be much more selective across countries. Big lending programs will be confined to countries that have the policy commitment, the minimal institutional capacity, and the public support to make them work. Elsewhere, the MDBs will have to stay engaged without lending (and the administrative and human resource costs of such engagement will have to be financed by "profits" on loans to other countries).

Seize an opportunity in the HIPC initiative -- selectivity: The HIPC (Heavily Indebted Poor Countries) initiative is another in a long series of debt relief programs for poor countries. But it is the first to include reduction of heretofore untouchable multilateral debt. There are legitimate concerns about the HIPC program: that it is too small in relation to the countries' tremendous development needs and may eat into future donor allocations; and that it provides no guarantee that forgiven debt will be translated into increased domestic spending on peoples' needs, especially in education and health.

But the initiative does have one clear advantage. There is good evidence that once recipient countries have accumulated high debt to multilateral institutions, all the donors go on lending -- independent of country policy and capacity -- apparently to ensure that the high-debt countries avoid falling into arrears to the multilaterals. HIPC thus represents an opportunity to correct an alarming trend of collapsing policy selectivity in countries with high multilateral debt. Even without additional donor resources, debt relief, by allowing donors to be selective, would ensure more funds for countries with good policies and adequate institutions -- and, of course, fewer for countries with bad policies and inadequate institutions. A return to selectivity in the donor community could create a virtuous circle by crowding in private flows to good-policy/low-debt countries.

The HIPC program appears to be necessary to ensure this result. But it is far from sufficient. In the future, all the donors, including the MDBs, have to be tougher -- keying new lending much more to achievements than to promises.

Re-juggle representation in these finance "clubs": Governance of the MDBs has been effective (compared to the one-country one-vote system in the United Nations) because decision-making has been relatively well aligned with financial responsibility and burden. The non-borrowers, especially the United States, have had more votes and more power because their paid-in and callable capital provided the basis for the banks' ability to borrow at low rates and thus lend at low rates. As the global economy has changed, however, two issues arise.

First, there is a growing discrepancy between the real costs associated with capital ownership in the MDBs and the power that countries have in the decision-making process. The cost to the United States associated with its capital or ownership shares in the World Bank amounts to the opportunity cost for U.S. taxpayers associated with the capital they hold in the bank. The actual annual cost of these contributions, however, is tiny, because no new appropriations are needed to support the regular World Bank operations, and the guarantee to cover World Bank debt in the extremely unlikely event of a default is virtually invisible to voters.

Second, the MDBs are increasingly embedded in a larger system of global governance. In the larger system, with growing interdependence, emerging market economies have become central actors, affecting as well as affected by the global financial and economic system. They ought to assume more responsibility and have more say in the MDBs, which are, after all, central forums for global economic decision-making. The MDBs would better be leaders than laggards in finding ways to increase the representation of borrowers in their own governance.

In short, representation and risk-sharing in these clubs also need to adjust to changing realities. In the case of the World Bank, for example, in the next decade the single largest shareholder -- the United States, with about 17 percent -- could lead an effort of the G-7 members to sell some of their shares so that countries like China, Brazil, and India could increase their shares, their voting power, and, literally, their ownership of the bank.

A BETTER FUTURE?

The World Bank and the regional banks are fundamentally membership organizations, or finance "clubs," that exist because the sum of the membership's credibility reduces borrowing costs for all members below what they would pay on their own. A better future for the MDBs is to move in the direction of becoming dynamic "clubs." That requires that they become more flexible and responsive in general, and more accountable to and representative of their borrowers.

(Note: The opinions expressed in this article do not necessarily reflect the views or policies of the U.S. government.)