Research Paper: MDB Securitisation and the Rating Agencies

This report examines the assumptions credit rating agencies make about MDB loans and shows how these assumptions could constrain the development of MDB securitisation issuance. Commissioned by MOBILIST and produced by Risk Control Limited, it explains how agencies rate MDBs and the tranches of the securitisations these banks issue. The report uses a stylised securitisation transaction to show how rating agency views of the underlying loan credit risk affect the economics of MDB securitisation, compared with assumptions based on actual MDB performance data.

MDBs face growing pressure to expand development lending while maintaining strong capital adequacy and high credit ratings. Securitisation and other credit risk transfer techniques can, in principle, help MDBs recycle balance sheet capacity by transferring part of the credit risk on existing loan portfolios to investors or guarantors.

But MDBs’ ability to use securitisation as a balance sheet management tool is strongly influenced by the methodologies applied by the major credit rating agencies. These methodologies differ in the extent to which they recognise MDB risk transfer and in the capital adequacy measures they emphasise.

The assumptions that rating agencies make about the underlying risk of MDB loan portfolios – and whether they appropriately reflect the nature of MDB loan risk – can have a material impact on the viability and expected benefit of an MDB securitisation.

Agency ratings impact MDB securitisations in two ways:

1. How the agencies rate MDBs. The agencies’ supranational rating methodologies affect the benefits that MDBs obtain from reductions in risk, as measured by the agencies’ capital adequacy metrics.

2. How the agencies rate securitisations. This affects the cost to MDBs of obtaining tranched credit protection when those tranches are rated.

For investors, credit rating agencies effectively act as gatekeepers in the securitisation market because their ratings determine the pricing of different tranches in a securitisation transaction. The senior tranches in a securitisation represent the lowest risk and are therefore the cheapest to finance. When agencies are more conservative in their evaluation of the Probabilities of Default (PDs) and Loss Given Default (LGD) rates of the underlying loans, these senior tranches are thinner. This impacts the Internal Rate of Return (IRR) of the very lowest tranche in the structure, the equity tranche.

Demonstrating the magnitude of these effects requires a structure in which tranches align with a set of ratings, which in turn align with tranche pricing. The report uses a structuring exercise to do exactly this. The exercise uses a hypothetical portfolio of Non-Sovereign Obligor (NSO) loans, structured as a Collateralised Loan Obligation (CLO) comparable to those recently issued by the International Finance Corporation (IFC). The point is to show how the rating agency’s view of the underlying loan credit risk affects the economics of the deal.

The results of the structured exercise illustrate the decisive impact agency assumptions can have on the economics of an MDB securitisation. The assumptions used in all three major credit rating agencies’ methodologies appear conservative relative to those implied by MDBs’ historical performance.

Comparing the two structures shows the direction and approximate scale of the effect of agency assumptions on deal economics, rather than estimates for any particular transaction. In this exercise, a securitisation based on GEMs data could double the securitisation’s expected benefit to the MDB compared to the assumptions credit rating agencies use. The Benefit to Cost ratio, which MDBs use to judge if a risk transfer is worth doing, rises from 0.7 to 1.4. The benefit outweighs the cost.

The expected return on the equity tranche, which MDBs retain in securitisation transactions, rises from near zero to 11.7% above SOFR. Underlying this is the Loss Given Default rate. Across the three agencies, this rate ranges from 50–69% in base-case scenarios and up to 81.5% and 96.9% in stressed scenarios. The GEMs data implies a base rate of 27%.

Risk Weights

A risk weight is the percentage applied to an exposure to calculate its risk-weighted assets (RWAs). The higher the risk weight, the more capital the MDB must hold against the exposure. Under Standard & Poor’s methodology, the key capital metric is the risk-adjusted capital (RAC) ratio, defined as Total Adjusted Capital divided by RWAs. A retained equity tranche is typically assigned a 1,250% risk weight; retained mezzanine and senior tranches receive rating-based risk weights, from 20% for AAA.

Internal Rate of Return (IRR)

The IRR is the annual rate at which the present value of the interest and principal payments on a tranche equals the tranche’s initial par. In the report, the expected IRR is the average of the IRRs across all simulations, and the expected spread is the difference between the expected IRR and the benchmark US dollar interest rate, based on the cost of borrowing cash overnight against US Treasury securities. Returns on loans and bonds are often quoted as a margin, or spread, above it.

Loss Given Default (LGD)

LGD is the share of an exposure that is lost when a borrower defaults, after recoveries. It is the complement of the recovery rate: the GEMs data for 1994–2024 report an average recovery rate of 72.9%, equivalent to an LGD of 27.1%. Standard & Poor’s and Fitch apply stressed LGDs when sizing a tranche to withstand a AAA or other high rating stress, reflecting the tendency of recoveries to be low when defaults are common. Moody’s applies the same LGD assumptions whatever the rating of the tranche.

The rating agency view is one part of the picture. Our companion study, How to Make a Success of MDB Securitisation, looks at what MDBs can do internally to make securitisation a regular part of how they manage their balance sheets.