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Rediscovering development banks

Topics covered:

  1. Inclusive growth and issues arising from it.

 

Rediscovering development banks

 

What to study?

For Prelims: What are development banks and how are they different from commercial banks?

For Mains: India’s experience with development banks, challenges faced by them and measures needed to boost their growth.

 

Context: In order to improve access to long-term finance, the government has proposed to establish an organisation to provide credit enhancement for infrastructure and housing projects, particularly in the context of India now not having a development bank and also for the need for us to have an institutional mechanism.

The announcement could have far-reaching implications for India’s financial system. It is a welcome initiative, but questions remain on its design.

 

What are development banks?

They are financial institutions that provide long-term credit for capital-intensive investments spread over a long period and yielding low rates of return, such as urban infrastructure, mining and heavy industry, and irrigation systems.

Development banks are also known as term-lending institutions or development finance institutions.

 

Features of development banks:

  1. Such banks often lend at low and stable rates of interest to promote long-term investments with considerable social benefits.
  2. Fund generation: To lend for long term, development banks require correspondingly long-term sources of finance, usually obtained by issuing long-dated securities in capital market, subscribed by long-term savings institutions such as pension and life insurance funds and post office deposits.
  3. Support by the government: Considering the social benefits of such investments, and uncertainties associated with them, development banks are often supported by governments or international institutions.
  4. Such support can be in the form of tax incentives and administrative mandates for private sector banks and financial institutions to invest in securities issued by development banks.

 

Genesis of development banks in India:

In the context of the Great Depression in the 1930s, John Maynard Keynes argued that when business confidence is low on account of an uncertain future with low-interest rates, the government can set up a National Investment Bank to mop up the society’s savings and make it available for long-term development by the private sector and local governments.

  • Following foregoing precepts, IFCI, previously the Industrial Finance Corporation of India, was set up in 1949. This was probably India’s first development bank for financing industrial investments.
  • In 1955, the World Bank prompted the Industrial Credit and Investment Corporation of India (ICICI) — the parent of the largest private commercial bank in India today, ICICI Bank — as a collaborative effort between the government with majority equity holding and India’s leading industrialists with nominal equity ownership to finance modern and relatively large private corporate enterprises.
  • In 1964, IDBI was set up as an apex body of all development finance institutions.

 

How were these banks financed initially?

As the domestic saving rate was low, and capital market was absent, development finance institutions were financed by:

  1. Lines of credit from the Reserve Bank of India (that is, some of its profits were channelled as long-term credit).
  2. Statutory Liquidity Ratio bonds, into which commercial banks had to invest a proportion of their deposits.

In other words, by sleight of government hand, short-term bank deposits got transformed into long-term resources for development banks. The missing capital market was made up by an administrative fiat.

 

Challenges faced by them:

  1. Development banks got discredited for mounting non-performing assets.
  2. This was mainly caused by politically motivated lending and inadequate professionalism in assessing investment projects for economic, technical and financial viability.
  3. After 1991, following the Narasimham Committee reports on financial sector reforms, development finance institutions were disbanded and got converted to commercial banks.
  4. The result was a steep fall in long-term credit from a tenure of 10-15 years to five years.

 

Way ahead:

Finance Minister’s agenda for setting up a development bank is welcome. However, a few hard questions need to be addressed in designing the proposed institution.

How will it be financed? If foreign private capital is expected to contribute equity capital (hence part ownership), such an option needs to be carefully analysed, especially in the current political juncture.

The design of the governance structure is fraught with dangers with many interest groups at work.

Therefore, the political and administrative leadership should carefully weigh in the past lessons to lay a firm foundation for the new institution.

 

Sources: the Hindu.

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