29th August – Rediscovering development banks

Finance Minister Nirmala Sitharaman’s press conference on August 23, announcing a slew of measures to boost the economy and financial market sentiments, had an interesting idea. It was about setting up a development bank.

Rediscovering development banks

What are development banks?

  • Development banks 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.
  • Such banks often lend at low and stable rates of interest to promote long-term investments with considerable social benefits.
  • Development banks are also known as term-lending institutions or development finance institutions. 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.

How do they differ from commercial banks?

Development banks are different from commercial banks which mobilise short- to medium-term deposits and lend for similar maturities to avoid a maturity mismatch — a potential cause for a bank’s liquidity and solvency. The capital market complements commercial banks in providing long-term finance.

Pioneers of industrialisation –

  • Industrialisation of continental Europe and Asia was, however, financed under the aegis of German-type universal banks (providing long- and short-term credit) and state-sponsored (or guaranteed) development banks underwriting the risks of long-term credit.
  • 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.

Experiments in India –

  • 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.

Failure –

  • Development banks got discredited for mounting non-performing assets, allegedly caused by politically motivated lending and inadequate professionalism in assessing investment projects for economic, technical and financial viability.
  • 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 five years.

Conclusion –

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. 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.

SourceThe Hindu

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