Rediscovering development banks

Relevance: Mains: G.S paper III: Indian Economy: Banking System

Context

  • The Union Finance Minster recently announced the setting up of a development bank.
  • The announcement could have far-reaching implications for India’s financial system.

What are development banks?

  • Development banks are financial institutions that provide long-term credit.
  • They are also known as term-lending institutions or development finance institutions.
  • It generally supports capital-intensive investments spread over a long period and yielding low rates of return.
  • E.g. urban infrastructure, mining and heavy industry, irrigation systems
  • Such banks often lend at low and stable rates of interest to promote long-term investments with considerable social benefits.

How do they work?

  • To lend for long term, development banks require correspondingly long-term sources of finance.
  • This is usually obtained by issuing long-dated securities in capital market.
  • These are subscribed by long-term savings institutions such as pension and life insurance funds and post office deposits.
  • The long-term investments associated here have notable social benefits as well as involve considerable uncertainties.
  • Given this, development banks are often supported by governments or international institutions.
  • Such support can be in the form of tax incentives and administrative mandates for private sector banks and financial institutions.
  • This is to help them invest in securities issued by development banks.

What is the recent proposal?

  • It was proposed to establish an organisation to provide credit enhancement for infrastructure and housing projects.
  • A development bank would enhance debt flow toward such projects.
  • It comes in the context of India not having a development bank and also for the need to have an institutional mechanism in this regard.
  • The overall aim is to improve access to long-term finance.
  • The announcement could have far-reaching implications for India’s financial system.

How did development banks evolve in India?

  • 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).
  • [This is the parent of the largest private commercial bank in India today, the ICICI Bank.]
  • It was a collaborative effort between the government with majority equity holding and India’s leading industrialists with nominal equity ownership.
  • The objective was to finance modern and relatively large private corporate enterprises.
  • In 1964, IDBI (Industrial Development Bank of India) was set up as an apex body of all development finance institutions.
  • As the domestic saving rate was low, and capital market was absent, development finance institutions were financed by – lines of credit from the RBI e. some of its profits were channeled as long-term credit, Statutory Liquidity Ratio bonds, into which commercial banks had to invest a proportion of their deposits.
  • In other words, with government’s role, short-term bank deposits got transformed into long-term resources for development banks.

How did they perform?

  • Development banks got discredited for mounting non-performing assets.
  • This was allegedly caused by politically motivated lending.
  • Inadequate professionalism in assessing investment projects for economic, technical and financial viability was also a reason.
  • After 1991, following the Narasimham Committee reports on financial sector reforms, development finance institutions were disbanded and got converted to commercial banks.
  • The result was a steep fall in long-term credit from a tenure of 10-15 years to 5 years.

How has it been for China?

  • China’s development banks include the Agricultural Development Bank of China, China Development Bank, and the Export-Import Bank of China.
  • These have been at the forefront of financing its industrial prowess.
  • After the global financial crisis, these institutions have underwritten China’s risky technological investments.
  • This helped it gain global dominance in IT hardware and software companies.
  • Likewise, Germany’s development bank, KfW, has been supporting long-term investment in green technologies and sustainable development efforts requiring long-term capital.

Way forward

  • The greater the backwardness of a country, the greater the role of the state in economic development.
  • This is particularly true in providing long-term finance to catch up with the advanced economies in the shortest possible time.
  • In this light, the 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.
  • The key one among them is the source of finance.
  • If foreign private capital is expected to contribute equity capital (hence part ownership), such an option needs to be carefully analysed.
  • The political and administrative leadership should carefully analyse the past lessons to lay a firm foundation for the new institution.

 

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