**5. Open questions: determinants of development banks' effectiveness in supporting SDG-aligned innovation**

To address the increasing financial demands of the 2030 Development Agenda and maximize their developmental impact, development banks need to possess specific

characteristics and operate within a favorable framework that enhances benefits and reduces potential costs. Economists and policymakers stress the importance of implementing appropriate policies and best practices to ensure the welfare-oriented role of development banks while mitigating the negative effects commonly associated with state-owned banks and enterprises, as documented in existing literature.

This issue raises several open questions that we believe theoretical and empirical research can contribute to, supporting policymakers in harnessing the maximum social benefits from the operations of these institutions. The key open questions can be summarized as follows:


Let us start with the first question: what should development banks finance? Firstly, development banks should refrain from investing in innovative projects that based on their characteristics (such as track record, guarantees, and time perspectives) may already attract private investors' resources without any need of additional public support. This mitigates the risk of crowding-out effects and enhances the benefits of blended finance. Intervention areas should focus on industries, activities, and types of enterprises where development banks have demonstrated expertise above the market average. This strategic approach is likely to serve as a positive signal for the market, a catalyst for private investors and mobilize financial resources toward desired areas. Enhancing the economic viability and profitability of innovation projects is crucial to attract additional funding for blended programs and public-private partnership arrangements, which are recognized as effective methods for achieving long-term public goals. At the same time, intervention areas must align with the received mandate of development banks to minimize the risk of inappropriate and politically motivated use of financial resources.

However, it would be erroneous to assume that the areas of intervention are clear and well-defined. This assumption hinges on the belief that either the bank's management or the government has a complete comprehension of the prevailing market failures and has the optimal approach to rectify them. As stated by Fernández-Arias et al. [58], "*the successful implementation of the development bank paradigm requires deep knowledge of market failures especially because economic development requires structural transformation and, in turn, structural transformation requires the creation of new activities which may be impeded by non-observable market failures*". It can be extremely difficult for policymakers to collect this information and consistently decide on the activities to promote. Addressing this issue still requires additional research efforts.

The second question pertains to the most effective intervention tools. Development banks enable economic progress by employing various intervention mechanisms, including direct or indirect loans, credit guarantees, and equity instruments such as venture capital, private equity, seed capital financing, and mezzanine financing [2, 58]. Existing empirical literature suggests that, through

### *Innovation and Global Sustainable Development: What Role for Development Banking? DOI: http://dx.doi.org/10.5772/intechopen.112062*

active participation as acquirers or investors in the corporate control market, development banks can effectively contribute to economic objectives such as innovation and societal challenges. Vandone et al. [7] emphasizes the significant role of equity investments in supporting innovation financing. Indeed, in their role of shareholders, development banks can enhance the management of target firms by leveraging their expertise and competencies. Additionally, they can acquire valuable insights into the market constraints influencing investment levels while facilitating the participation of other potential investors [58]. As stated by Cefis and Marsili [75], M&As offer small firms an opportunity to surpass the innovation threshold, increasing the likelihood of transitioning from non-innovators to innovators and initiating the sale of innovative products.

Furthermore, development banks have assumed an increasingly vital role in syndicated lending, a prominent external funding channel typically utilized by global corporations. Participation in syndicate loans effectively mobilizes financial resources and supports risky projects [36, 40, 76]. Development banks' involvement in syndicated loans can also mitigate political risk [77] and have a "certificate effect" that positively impacts the structure of syndication by increasing the number of participating lenders and fostering broader loan ownership [37].

Given the diverse intervention possibilities and available instruments, further theoretical and empirical literature is certainly deserved to identify and delineate the most suitable and effective tools based on the objectives specified by development banks.

The third point pertains to the essential characteristics that development banks should possess to optimize their social and environmental impact while contributing to innovation. Financial sustainability stands out as a crucial aspect. While development banks have broader objectives beyond profitability, they must balance socio-economic goals with efficiency and profitability requirements to ensure their financial strength and stability [9, 78]. As argued in [14, 79], considering socio-economic goals and financial stability together is crucial for achieving a balanced and effective approach. Policymakers increasingly emphasize the need for development banks to achieve their objectives while maintaining financial stability and optimizing their balance sheets [4, 59]. For example, the Addis Agenda calls on multilateral development banks to make "optimal use of their resources and balance sheets, consistent with maintaining their financial integrity" [41]. Many national promotional banks today explicitly prioritize financial sustainability in their statutes. Multilateral Development Banks [80] also emphasizes the importance of managing risks and preserving credit ratings. To this aim, it is desirable for the size of public banks to be proportionate to their mandate. Smaller development banks face potential limitations, as highlighted in [9]. Their lower financial leverage ratio results in reduced capital generation, even with similar profitability levels. Moreover, smaller banks often rely more on short-term funding and exhibit lower-cost efficiency due to their size. They are also more susceptible to credit risk, a challenge commonly associated with commercial banks.

However, financial efficiency is not sufficient by itself. To achieve their objective minimizing political failures, development banks must adhere to sound banking principles and implement optimal banking standards and practices. Moreover, to avoid political lending, the corporate governance of development banks should ensure the existence of internal bodies whose appointment does not align with the political cycle [58]. This would help mitigate the risk of political interference in their decisionmaking processes. More in general, to effectively contribute to the attainment of the SDGs, development banks must align their activities with the recommended governance characteristics outlined in the Sustainable Development Report [1]. These characteristics not only encompass effectiveness, but also transparency, accessibility, and inclusiveness. Embracing these principles becomes imperative for development banks as they strive to fulfill their role in sustainable development. Transparency fosters accountability and trust. Accessibility and inclusiveness further promote equal opportunities and social equity.

The final aspect worth considering is the institutional context. The institutional context in which development banks operate significantly influences their effectiveness in achieving objectives. In countries with weaker democratic governance, transparency, and institutional checks and balances, studies suggest a higher likelihood of opportunistic pre-electoral manipulation [81, 82]. Insufficient autonomy of development banks can lead to executive influence for incumbent re-election prospects. Consequently, in flawed democracies, development banks may deviate from their intended mandates and align with short-term political objectives. Frigerio and Vandone [55] finds no empirical evidence supporting opportunistic manipulation in fully democratic countries. However, politically driven lending practices are observed in countries with less robust political institutions, particularly during election years compared to the rest of the banking system. Consistently, Clò et al. [62] highlights that higher institutional quality positively impacts the patenting activity of firms targeted by European development banks for their equity investment. This effect can be explained by the influence of institutional quality on appointment procedures, internal governance, and monitoring mechanisms. Development banks in countries with high institutional quality are more likely to prioritize internal stability, transparency, and long-term socially valuable goals. In contrast, low-quality institutions are more prone to political capture, personal objectives, and misallocation of resources. Therefore, institutional quality significantly affects the orientation toward innovation and management capability of development banks.
