The End Of Development Finance

FINANCIAL liberalisation is leading to the death of development banking in the

country. Close to two years back, on March 30, 2002, the Industrial Credit and
Investment Corporation of India (ICICI) was through a reverse merger integrated with
ICICI Bank. This was the result of a decision (announced on October 25, 2001) by ICICI
to transform itself into a “universal bank” that would engage itself not only in
traditional banking but investment banking and other financial activities. The proposal
also involved merging ICICI Personal Financial Services Ltd and ICICI Capital Services
Ltd with the bank, resulting in the creation of a financial behemoth with assets of more
than Rs 95,000 crore. The new company was to become the first entity in India to serve
as a financial supermarket and offer almost every financial product under one roof.
 
DESTROYING DEVELOPMENT BANKS
Since then similar moves have been underway to transform the other two principal
development finance institutions in the country, the Industrial Finance Corporation of
India (IFCI), established in 1948, and the Industrial Development Bank of India (IDBI),
created in 1964. In early February, finance minister Jaswant Singh, announced the
government’s decision to merge the IFCI with a big public sector bank, like the Punjab
National Bank. Following that decision, the IFCI board has approved the proposal,
rendering itself defunct.
 
More recently the Parliament has, after debating the matter for more than a year,
approved the corporatisation of the IDBI and paved the way for its merger with a bank
as well. When the bill was put through with some difficulty in the Rajya Sabha, it
appeared that the government had provided two commitments. The first was that the it
would retain a majority stake in the entity into which the IDBI would be transformed.
The government currently has a 58.47 per cent stake in IDBI. And, second that the
development finance emphasis of the institution would be retained. But already doubts
are being expressed about the government’s willingness to stick to the first of these
commitments. And once the merger creates a universal bank as a new entity, with
multiple interests and a strong emphasis on commercial profits, it is unclear how the
second commitment can be met either.
 
These developments on the development-banking front do herald a new era. An
important financial intervention adopted by almost all late-industrialising developing
countries, besides pre-emption of bank credit for specific purposes, was the creation of
special development banks with the mandate to provide adequate, even subsidised, credit
to selected industrial establishments and the agricultural sector. According to an OECD
estimate quoted by Eshag, there were about 340 such banks operating in some 80
developing countries in the mid-1960s. Over half these banks were state-owned and
funded by the exchequer; the remainder had a mixed ownership or were private. Mixed
and private banks were given government subsidies to enable them to earn a normal
rate of profit.
 
REASONS FOR THEIR CREATION
The principal motivation for the creation of such financial institutions was to make up for the
failure of private financial agents to provide certain kinds of credit to certain kinds of clients.
Private institutions may fail to do so because of high default risks that cannot be
covered by high enough risk premiums because such rates are not viable. In other
instances failure may be because of the unwillingness of financial agents to take on
certain kinds of risk or because anticipated returns to private agents are much lower
than the social returns in the investment concerned.
 
In practice, financial intermediaries seek to tailor the demands for credit from them
with their funds by adjusting not just interest rates, but also the terms on which credit is
provided. Lending gets linked to collateral, and the nature and quality of that collateral
is adjusted according to the nature of the borrower and supply and demand conditions
in the credit market. In the event, depending on the quantum and costs of funds
available to the financial intermediary, the market tends to ration out borrowers to
differing extents. In such circumstances, borrowers rationed out because they are
considered risky may not be the ones that are the least important from a social point of
view.
 
These problems can be aggravated because certain kinds of insurance markets for
dealing with risk are absent and because in some (especially, developing-country)
contexts certain kinds of long-term contracts may not just exist. They need to be created
by the state, and till such time state-backed lending would be needed to fill the gap.
 
Industrial development banks also help deal with the fact that local industrialists may
not have adequate capital to invest in capacity of the requisite scale in more capital-
intensive industries characterised by significant economies of scale. They help promote
such ventures through their lending and investment practices and often provide
technical assistance to their clients. Some development banks are expected to focus on
the small-scale industrial sector, providing them with long-term finance and working
capital at subsidised interest rates and longer grace periods, as well as offering training
and technical assistance in areas like marketing.
 
Fundamentally of course, development banking is required because social returns exceed private
returns. This problem arises because private lenders are concerned only with the return
they receive. On the other hand, the total return to a project includes the additional
surplus (or profit) accruing to the entrepreneur. The projects that offer the best return to
the lender may not be those with the highest total expected return. As a result good
projects get rationed out necessitating measures such as development banking or
directed credit.
 
THE ROLE OF DEVELOPMENT BANKS
It must be said that development banks have played an important role in the Indian
context. In his deposition before the Parliamentary Standing Committee on Finance
(1999-2000), on September 18, 2000, the Managing Director of ICICI stated:
“disbursement by FIs constituted around fifty per cent of gross fixed capital formation
by the private corporate sector in the pre-liberalised era. If you see the financial
institutions disbursement versus bank credit to industry right from 1951 to the last year,
we see that financial institutions have provided significantly more credit for creation of
capital in industry in India. It has grown year after year … thus, the FIs have played a
pivotal role in the development of Indian industry and have fulfilled their initial objective i.e. to
spur industrialisation in the country over the last three to four decades.”
 
The corporatisation, transformation into universal banks and subsequent privatisation
of the DFIs is bound to undermine this role of theirs. The justification for the conversion
to universal banking as provided by the Industrial Investment Bank of India (IIBI) in a
written reply to the Parliamentary Standing Committee indicates this: “Since
compartmentalisation of activities leads to greater transactions cost and inefficiency, no
financial intermediary can survive competition if it does not allow itself flexibility to
change. In the new financial environment, IIBI is of the opinion that a financial player
may be either placed naturally for resources like a commercial bank, or may be a pure
financial service provider and retailer like the NBFCs. Still another option is to build a
financial supermarket where all the services are available under a single umbrella. The
advantages are that they would be free to choose the product mix of their operations
and configure activities for optimum allocation of their resources.”
 
The CEO of ICICI made clear what this means in terms of emphasis: “When we were set
up, our role was to meet long term resource requirements of the industry. With
liberalisation the role has slightly changed. It became developing India’s debt market,
financing India’s infrastructure development, etc. With globalisation, I think, the role is
set to change further. Now we have to stress on profitability, shareholder value,
corporate governance, while at the same time not losing sight of our goals – the goals
that were originally set for us – and the goals that were set up in the interim with
liberalisation.” Unfortunately, the emphasis on those goals would remain only with
regulation. But regulation is diluted by liberalisation.
 
IMPACT OF LIBERALISATION
 
There is another way in which the gradual dissolution of the core of India’s
development banking infrastructure is related to the process of liberalisation. This was
the effects of liberalisation on the profitability of an institution like the IFCI, for
example. According to the D Basu Expert Committee, which was appointed by IFCI's
governing board to examine the causes of the large NPAs accumulated by the
institution and suggest a restructuring, immediately following its corporatisation and
initial public offering in 1993, IFCI embarked upon a programme of rapid expansion of
business. To scale up the volume of business it increasingly raised resources from the
debt markets. This was at a time when interest rates were relatively high. In order to
cover the high cost borrowings, the institution was forced to make investments in what
were considered high yielding loan assets.
 
Unfortunately, this occurred at a time when financial liberalisation had put an end to
the traditional consortium mode of lending, in which all major financial institutions
collaborated in lending to a single borrower as per a mutually agreed pattern of
sharing. Liberalisation was introducing an element of competition among financial
institutions. In the event, in search of high returns IFCI chose to take relatively large
exposures in several greenfield projects (notably in the steel and oil sectors).
 
For a number of reasons these projects did not deliver on their promise. Many of these
projects had expected to raise substantial equity from the capital market as well as from
the internal resources of group companies. Depressed conditions in the capital market
put paid to the first. Recessionary conditions limited the second. Many of these groups
were in the traditional commodity sectors such as iron and steel, textiles, synthetic
fibres, cement, sugar, basic chemicals, synthetic resins, plastics, etc. Besides the general
recessionary environment, some of these sectors were particularly affected by the
abolition of import controls and the gradual reduction of tariffs. Internal resource
generation, therefore, fell short of expectations. As a result, with inadequate own-
financing, in the pipeline many of these projects suffered from cost- and time-overruns.
 
Unlike other financial institutions, IFCI had not diversified into other types of
businesses. Project finance still accounted for 94 per cent of IFCI's business assets. As a
result, the impact of NPAs arising from the factors cited above was the greater in the
case of IFCI than in the case of other institutions. In addition, there was sharp rise in
IFCI's gross NPA level in 1998-99 (Rs 5,783.56 crore as against Rs 4,159.84 crore in the
previous year) as a result of the implementation of the mandatory Reserve Bank of
India guidelines for classifying non-performing assets. As a result, certain loans,
particularly those relating to projects under implementation, which had been treated as
performing assets in earlier years, had to be classified as non-performing.
 
The Basu Committee had noted that some of the factors referred to above such as
impact of trade policy liberalisation and tariff reduction, recessionary conditions in the
late 1990s, depressed conditions in the capital market, etc, affected other DFIs and
banks as well. However, the impact was particularly pronounced in the case of IFCI, as
the concentration of risk relative to net worth was much higher. Also, as already stated,
other DFIs had started diversifying into non-project related lending and business. It was
difficult to survive as a development finance institution in the new environment.
 
Thus the decline of development finance is clearly related to the process of economic
liberalisation. However, as a number of industry associations have noted in recent times,
it hardly is true that in a time of growing competition for Indian firms from
international business and a growing liberalisation-induced shift in the investment and
lending practices of banks and NBFCs away from manufacturing, state support for
domestic private investment is not relevant. But given the ethos of liberalisation this
does not seem to matter.