**3. Economic fundamentals of development banks: utility and potential weaknesses**

The existence of development banks is justified by the theory of market failure, which recognizes the inability of idealized price-market institutions to sustain desirable activities or prevent undesirable ones [23]. Market failures occur when markets are inefficient and fail to reach the (Pareto-)optimal level of resource allocation, often due to factors such as imperfect information, externalities, or managerial biases [24–28]. The issue of information asymmetries, in particular, has been established as pervasive in financial markets, due to their high dependence on information [29]. Underinvestment in long-term projects with positive externalities can also arise as a consequence of the divergence between social and private returns [5] and the shorttermism and high opportunity costs characterizing the private financial sector [30].

The establishment of development banks is only one of the different ways the state can intervene in the financial markets to overcome these failures [31, 32]. However, development banks are suitably positioned to provide solutions to inefficiencies and shortcomings within the economic system [2, 14, 16, 33]. Because of their peculiar characteristics, they are proved to be capable to provide *patient capital*, which is highly needed for strategic investments in infrastructure, export initiatives, housing, and socially impactful projects like climate finance, renewable energy, and food security [34, 35]. Furthermore, development banks actively engage in syndicate collaborations with private commercial banks, which can be attracted by their governmental connections and risk management expertise [2, 36, 37]. Risk mitigation measures employed by development banks include risk-sharing approaches and the preferred creditor status they typically enjoy, which often extends to financial institutions participating with them in syndicate lending. These measures enable development banks to attract private financing at a larger scale and facilitate *blended finance* programs, expanding their impact [38–40]. The Addis Ababa Action Agenda [41] defines blended finance as the combination of "concessional public finance with non-concessional private finance and expertise from the public and private sector". A group of nine development financial institutions1 disclosed financing projects worth more than \$11.2 billion through blending strategies in 2021 [42].

Contemporary development banks are recognized not only for their role in promoting efficient market functioning but also for their increasing emphasis in the *creation* of new market landscapes, fostering innovation, and improving institutional frameworks. Indeed, these banks facilitate responses to global challenges that require strong collaboration between private and government entities. They particularly support high-risk projects in sectors like high-tech, emerging industries, start-ups, and research and development (R&D) investments, which typically face major obstacles such as information asymmetries, evaluation difficulties, lack of guarantees, and limited track records [33, 43].

While it is widely acknowledged that development banks play a crucial role in addressing market failures and fostering socially beneficial endeavors, however it remains a critical question whether they are the optimal entities to pursue these

<sup>1</sup> These nine institutions include: the International Finance Corporation, the African Development Bank, the Asian Development Bank, the Asian Infrastructure Investment Bank, the European Bank for Reconstruction and Development, the Association of European Development Finance Institutions, the European Investment Bank, the Inter-American Development Bank Group, and the Islamic Corporation for the Development of the Private Sector.

objectives and what weaknesses may undermine their effectiveness. Development banks not only receive specific mandates from the governments, but they are also predominantly state-owned. This raises the question of whether development banks can give rise to concerns similar to those typically associated with state-owned banks. Indeed, potential weaknesses in the operations of state-owned banks should not be overlooked.

State-owned banks, often viewed as less efficient and profitable compared to private banks, have faced criticism due to their management by political bureaucrats. Undesirable consequences such as resource misallocation and value erosion can arise due to political interference and inefficiencies [44–49]. The misallocation of funds by state-owned banks can be attributed to two main hypotheses: the *soft-budget constraints* hypothesis and the *rent-seeking* hypothesis. The former posits that abundant and lenient capital access leads state-owned banks to approve poor investments and use public funds to bail out failing companies [44, 50]. The latter posits that politically connected entrepreneurs receive preferential treatment in terms of interest rates and credit accessibility [48, 51–54]. Influence from incumbent policymakers on state-owned banks to excessively stimulate economic growth before elections further complicates matters. Indeed, the decisions and actions of policymakers can have a profound impact on the operational dynamics of development banks, potentially influencing their lending practices, investment decisions, and overall effectiveness [55]. This issue is strictly related to the theory on political business cycles, which explores the political factors shaping macroeconomic fluctuations [56].

All these matters are clearly relevant to the debate concerning the appropriateness of development banks in addressing market failures and the conditions under which they are beneficial, as well as the existence of alternative approaches. However, it is essential to recognize that previous literature often treats state-owned banks as a homogenous category, despite the substantial differences in mission, business models, activities, and target market segments that characterize development banks. Unlike commercial state-owned banks, development banks typically receive a clear mandate to provide long-term capital for promoting innovation and sustainable growth and, consequently, possess specialized expertise within their areas of operation.

Development banks can mitigate political pressures and disrupt the intertwined relationship between state-owned banks and politics through various factors. One notable factor is the divergence in timelines between the investment cycle of development banks and the electoral cycle. While political opportunism often leads to a short-sighted and immediate focus on gaining political advantages during electoral periods, the existence of long-term objectives requires a foresighted perspective in the financing and implementation of relevant projects [2]. Given the complexity of long-term projects and their limited flexibility for abandonment or modification, achieving political objectives through lending activities becomes more complex in the case of development banks. Moreover, most development banks typically concentrate their interventions in predetermined sectors, industries, or geographical areas, consistently with the statutory mandate they received. This targeted and tailored approach reduces the scope for discretion, political opportunism, and resource misallocation. Additionally, development banks are called to mobilize private resources and expertise and to act as a catalyst to channel these resources toward desired sectors and projects [40, 57]. This emphasis on private co-financing further diminishes the likelihood of politically motivated lending toward non-viable projects, since these would lack support from private investors. Last but not least, due to their role in public-private collaboration, development banks are in a favorable position for

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

observing (and dealing with) both market failures and government failures at the same time [58].

Through these means, development banks attenuate political influence, safeguard against resource misallocation, and enhance project alignment with sustainable economic and social objectives. From this perspective, the focus of development banks on long-term investment themes yields dual benefits. On the one hand, it addresses credit deficiencies arising from market failures, particularly during specific cyclical phases (e.g., post-global financial crisis deleveraging). On the other hands, it restricts the autonomy of development banks, shielding them against short-term political opportunism and electoral cycles. With these necessary premises established, we can now proceed to discuss the empirical literature on the intervention of development banks in the realm of innovation. This discussion encompasses references to both empirical economic literature and specific case studies, providing tangible examples of their involvement and impact.
