It is widely rumored that a new development finance institution (DFI), in some shape or form, is likely to be announced by finance minister, Nirmala Sitharaman as part of her budget proposals to be presented on February 1, 2021.
The Union Budget 2021 offers the central government an extraordinary opportunity to address India’s economic and financial challenges amidst the economic slump triggered by the COVID-19 pandemic.
The upcoming budget has the potential to lay down a roadmap for a people-centered recovery by providing immediate relief measures to those who have lost livelihoods and stimulating the economy by increasing government spending that would boost aggregate demand, crowd in private investment, and create jobs.
In this context, setting up government-backed DFIs focused on building social and physical infrastructure are the best possible solutions given the extent of market failures in healthcare and lack of patient capital to invest in development projects having large capital requirements and long gestation periods.
While the design and other details of the new DFI are still unknown, analysts believe that it would focus on infrastructure and housing projects, as signaled by Sitharaman some time ago. She had said: “In order to improve access to long-term finance, it is 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. So, this will enhance debt flow toward such projects.”
After decades of free-market orthodoxy, other countries too are revisiting the role of DFIs to meet the challenges of today, and tomorrow, as these institutions continue to play an important role in the economies of China, Brazil, Singapore, South Korea, Japan and Germany.
In the aftermath of the 2008 financial crisis, the policy pendulum is swinging towards deploying DFIs to revive the economy and support new ventures. Post-crisis, some developed economies have established DFIs with a special emphasis on promoting green finance, new technologies, SME development and startups.
The UK, for instance, established Green Investment Bank in 2012 to finance specifically green projects. Since DFIs can have a direct role in combating the COVID-19 pandemic and its fallout, it has added new momentum to this swing.
Not a new phenomenon
DFIs, also known as development banks, are not new in India. In independent India, three national-level DFIs –Industrial Finance Corporation of India (now known as IFCI), Industrial Credit and Investment Corporation of India (ICICI), and Industrial Development Bank of India (IDBI) – were established during 1948-64 to provide long-term financing in the industrial sector.
In the 1970s and 80s, some sector-specific DFIs ― such as EXIM Bank, National Housing Bank, and Housing and Urban Development Corporation ― were established. Besides, state-level DFIs were set up by state governments to provide concessional lending to small and medium enterprises.
However, DFIs and development banks’ role in financing industrial and other long-term projects drastically diminished with the withdrawal of concessional funding via long term operation (LTO) funds from the Reserve Bank of India (RBI) under financial reforms introduced in the early 1990s. The change in policy environment forced DFIs to raise financial resources at market-related rates, making their business model unviable.
Consequently, Industrial Investment Bank of India was folded up while ICICI and IDBI were converted into full-fledged commercial banks in India. The financial position of state-level DFIs also deteriorated because of the increase in non-performing assets (NPAs) and the weakening of the states’ fiscal resource capacity.
As compared to commercial banks, DFIs and development banks offer numerous advantages, some of which are listed below.
First, unlike commercial banks, DFIs do not operate with the primary objective of maximising profits. They combine profit-making with meeting development objectives. DFIs can remain commercially viable while fulfilling their non-commercial objectives. Their ability to look beyond profit-and-loss considerations makes them unique to pursue and deliver on broader societal goals. In comparison, commercial banks focusing on short-term financial returns may undermine the pursuit of societal goals.
Second, DFIs have a public policy mandate that enables them to finance public health systems and other socially desirable projects, support small businesses and local communities, and provide funds to long-term projects linked to the UN’s sustainable development goals. As discussed elsewhere, DFIs are widely considered the best policy instruments to mobilise long-term resources for socially desirable projects with high social returns.
Depending on the national context, it is likely that some DFIs may focus on infrastructure and industrial development, while others may pursue social development and inclusive growth. The DFIs can channel resources to new industries, sectors, regions and development initiatives that commercial banks cannot or be unwilling to finance.
The DFIs can also invest in public goods and services (such as mass transport systems) and promote climate-friendly infrastructure development.
Third, DFIs can also provide counter-cyclical financing during financial crises. As witnessed in Brazil, Poland, and Germany during the 2008 crisis, the DFIs stabilised credit flows by scaling up their lending operations when private banks drastically curtained their lending activities.
Fourth, DFIs can provide medium- and long-term credit, supplementing the commercial banks which usually offer short-term working capital financing. In India, commercial banks have failed to fill the vacuum left by DFIs in the medium- to long-term lending segment.
Commercial banks face a maturity mismatch. Commercial banks borrow short from depositors with a maximum tenure of 10 years for fixed deposits and, therefore, cannot offer medium- and long-term loans for projects requiring 15-25 years of funding.
Besides, many commercial banks (both public and private) are already struggling to cope with rising bad loans and stretched balance sheets. Hence, the sharp decline in long-term credit witnessed in the last two decades has revived the demands for creating new DFIs and development banks in India.
Role of DFIs in COVID-19 response
In a post-COVID-19 world, the DFIs could be the natural partners in financing and investing in the medical supply chains and logistics infrastructure. Let’s suppose the procurement and distribution of COVID-19 vaccines are not highly profitable due to price controls or other regulations. In that case, commercial banks may not be willing to invest or finance such businesses.
But as we all know, the COVID-19 pandemic is the defining global health crisis of our time. In such circumstances, the DFIs can immediately channel resources to firms (public and private) involved in the procurement and distribution of vaccines and other medical supplies, despite expecting lower financial returns.
As governments around the world prepare to build a resilient future beyond COVID-19, they should envisage DFIs as an integral part of strategies and structures to tackle the next public health crisis, rather than relying on these institutions on an ad hoc basis when the crisis hits.
In fact, the role of DFIs and development banks goes much beyond managing health crises. Given their tremendous potential, it is imperative to reimagine the role of DFIs in the 21st century. In the 20th century, DFIs were primarily addressing credit market failures. However, their role is far more significant in the 21st century as the DFIs have the full potential to tackle big societal challenges such as climate change, food security, inequality, and inclusive growth. The DFIs can be a vital instrument in any government’s policy toolbox for creating societal and public value.
Despite their potential, DFIs face numerous internal and external challenges that need to be addressed. First and foremost, the governance of DFIs matters a lot since these are public financial institutions dealing with public money. The DFIs should be transparent in their operations and accountable not only to the government but also to all stakeholders and the public at large.
In the Indian context, governance issues need to be given more attention as we have seen the good, bad and ugly sides of lending practices by a wide range of DFIs in the country.
To illustrate, take the case of Infosys Limited, an Indian IT company with global footprints. In the 1980s, when Infosys approached several commercial banks (including Citibank and Bank of America) seeking a Rs 5 million loan during its infancy, not a single bank offered the loan to the company.
Finally, Infosys approached two state-level DFIs, namely Karnataka State Financial Corporation and Karnataka State Industrial Investment and Development Corporation. Both these DFIs quickly sanctioned the loan to Infosys to expand its business. With a $72 billion market capitalisation and annual revenue of $13 billion in 2020, Infosys now does not need any financial support from DFIs or commercial banks. However, without financial support in the infancy stage from the DFIs, Infosys would not have embarked on its successful journey.
On the other hand, Housing and Urban Development Corporation (HUDCO), a national level DFI established to provide long-term finance for housing and urban development programmes, gave loans to an 18-hole golf course and a five-star luxury hotel at Jaypee Greens Golf Resort in Greater Noida.
In a country like India with over 100 million slum dwellers, financing a golf course should not be a priority for a DFI. The HUDCO has also financed premium serviced apartments on the outskirts of Delhi. Such lending practices by HUDCO violate its social mandate to meet the housing needs of the poor and disadvantaged sections of the country.
The National Housing Bank (NHB) is a prime example of poor internal controls and governance systems. In 1988, the NHB was set up as a subsidiary of the RBI to regulate and finance housing finance companies in India. In 1992, senior officials of NHB conspired with Harshad Mehta, a stockbroker, to defraud the NHB of Rs 7 billion. Strange but true, a large sum of NHB’s money found its way into the personal bank account of Mehta, who used it to manipulate stock prices.
Some pertinent questions
One can go on citing such instances, but the mixed record of positive and negative experiences raises a number of questions that need to be addressed before setting up a new DFI: has the finance ministry learned the right lessons from past experience with DFIs, especially Infrastructure Development Finance Company and India Infrastructure Finance Company Limited that were set up in post-liberalisation period to finance infrastructure?
Would the design of a new DFI be qualitatively different from earlier institutions? Would the new DFI follow key principles of good governance – transparency, participation, inclusion, and accountability – in the conduct of its business? What about checks and balances to prevent corrupt and fraudulent lending practices?
Would the new DFI follow strict environmental, social and human rights safeguards? Would it collaborate with other stakeholders such as local communities, NGOs, academia and citizens? What about policy coherence and interlinkages with the sustainable development agenda?
These are all critical issues that cannot be overlooked while rushing to step up a new development finance institution in India.
Lessons from past experiences
To ensure that the new DFI is soundly managed, adheres to its distinct goals and delivers real public value, the following are some suggestions drawn from past experiences in India.
First, if the central government wants the new DFI to deliver on its promise, it should be actively owned and managed. The new DFI should be well-capitalised with direct financing by the government and the RBI. Later on, the new DFI could tap additional resources through financial markets and international financial institutions, but the bulk of its resources should be made available by the government.
If the central government is not committing to contribute large sums of money, it should abandon setting up a new DFI.
The government should shun a purely market-driven approach towards DFI’s funding model. In a market-driven situation, the new DFI’s business model would become unviable if it is asked to raise long-term resources from financial markets at rates determined by market forces and asked to provide long-term credit to infrastructure projects having large capital requirements and long gestation periods.
Second, the mandate of the new DFI should be clearly articulated, and its board of directors and senior management team should clearly understand its purpose and objectives and their role in achieving this.
Third, the quality of internal governance and management systems would also play an essential role in its functioning. The board members must be professionally competent, not political appointees as often the case with state-owned banks and financial institutions.
It is also essential that the board of directors and the senior management team should have relevant expertise and experience to manage a DFI, not an easy task to hire talented people given the differences between public and private sector salaries in India. Even though the ownership remains with the government, its senior management team should have operational autonomy to run the new DFI’s day-to-day operations.
Fourth, its board and senior management team should commit to integrity and be held accountable for their actions by the government, regulatory agencies, and the wider public.
Fifth, since the government would be both the owner and the regulator of the new DFI, it should establish a clear ownership policy, ensuring that it will regulate the new entity in a transparent and accountable manner, avoiding any potential conflict of interest.
Finally, by combining transparency with participation, the new DFI should increase engagements with the stakeholders and the broader public beyond banking professionals’ little world.
To conclude, setting up a new DFI in India through budgetary and legislative measures is not a difficult task, but big challenges will emerge once established to ensure that it is well-capitalised, well-managed and remains committed to its distinct goals and core values.
Kavaljit Singh is director of Madhyam, a policy research think-tank, based in New Delhi.