In the aftermath of the floods in 2022, Pakistan’s financial sector was in crisis. But for different types of financial institutions, this crisis didn’t look the same. For microfinance banks, this was a crisis of capital adequacy; as non-performing loans (NPLs) in flood-impacted areas increased, capital was eroded, and capital adequacy fell from a regulatory minimum of 15% to 11.7%. For non-regulated MFIs, however, this was a crisis of liquidity. As they are unable to take deposits, these MFIs were reliant on borrowing from the financial sector and, as this dried up, they faced significant pressure on liquidity.
The 2022 floods revealed that resilience financing is not one-size-fits-all. Different types of institutions require many types of financing instruments, and their needs vary over time and according to the risk profiles of different climate hazards. CGAP has drawn together these various types of financing from different sources into a unified vision of what a well-financed, climate-resilient, inclusive financial sector requires, which we call the Climate Resilience Financing Stack.
Within this stack, a range of potential financing instruments exists to help financial institutions do three things.
1. Mobilizing long-term climate adaptation financing
Climate change is increasing the need for long-term investments that increase the adaptive capacity of people and MSMEs. These resilience-building investments typically require unusually patient capital, often at below-market rates. This is a natural entry point for DFIs, who have plenty of experience investing debt and equity in inclusive FSPs and are already starting to do this for climate resilience – for example, BII has invested $75m in HBL in Pakistan to support the climate resilience of smallholder farmers. But this is also a place where we see multilateral climate funds playing an expanded role, to help orient FSPs towards adaptation investments.
In one of the first examples we have seen of a climate fund lending through a financial institution, GCF provided a concessional loan to CRDB Bank in Tanzania to on-lend for climate adaptation and resilience measures in the agriculture sector.
2. De-risking lending through Climate risk financing
To de-risk lending to customers facing higher levels of climate exposure, financial service providers often require some form of guarantee or first loss that reduces their own exposure to climate-related risks. As CGAP has shown, FSPs are otherwise likely to pull back from climate-vulnerable segments, regions, and value chains. By covering a portion of climate-related losses, such mechanisms can enable and incentivize lending for clients that might otherwise be seen as too exposed to climate risks. While plenty of such mechanisms currently exist in the market, most focus on larger projects; very little is there to support the adaptation needs of climate-vulnerable households and small businesses.
3. Building liquidity buffers through Contingent financing
Climate change is making liquidity needs less predictable and more correlated with extreme weather patterns. Contingent financing refers to various financing instruments that are triggered by a particular pre-agreed event, typically a significant climate-related shock like flooding or drought.
It is typically in the form of a line of credit, which can be anticipatory, to provide emergency funding to prepare ahead of an inevitable event, or post-shock liquidity to be lent to customers to recover from the event. For example, the World Bank’s Resilient and Accessible Microfinance project in Pakistan provides loans through a contingent liquidity facility to microfinance institutions after heavy flooding to support the resilience and recovery of the institutions and their customers. Other financing instruments can have contingency clauses built into them, such as climate-resilient debt clauses that automatically pause repayment when an event is triggered.
The idea of a financing stack in climate adaptation and resilience is not new; many already exist and serve different types of funders and investors. However, bringing these instruments together is crucial for the future of climate finance. The examples used in this blog come from a DFI, a climate fund, and the disaster risk financing section of a multilateral development bank; these institutions work in similar spaces but often not together. This disconnect weakens their potential leverage when it comes to crowding-in financing from impact investors and larger pools of institutional capital. To mobilize the levels of finance we need for climate adaptation and resilience, and ensure that that financing reaches the people that need it most, we need a more coordinated approach where each institution, with its own impact mandate and risk tolerance, invests creatively to meet the varying needs of inclusive financial service providers.
This is already happening to an extent – for example, Cofides, the GCF, and the EU are all invested in Gawa Capital’s Kuali fund, which supports microfinance institutions for climate resilience. This indicates a huge opportunity for similar models to grow the quantity and quality of climate resilience financing.
Over the coming months, CGAP will unpack how DFIs, climate funds, and investors can each contribute to a stronger financing stack — one that ensures climate finance reaches inclusive financial providers and, ultimately, the people most affected by climate change.
