Industrial Development Banks – As a Concept


An important institutional innovation in many late-industrialising developing countries was the creation of what are broadly called development banks, which most often are public or joint sector institutions. Development banks are in the nature of “universal banks” undertaking a wide range of activities besides those undertaken by commercial banking institutions. Commercial banks, which mobilise finance through savings and time deposits, acquire liabilities that are individually small and protected from income and capital risk, are of short maturity and are substantially liquid in nature. On the other hand, the credit required for most projects tends to be individually large, subject to income and capital risk and substantially illiquid in nature. Consequently, commercial banks conventionally focus on providing working capital credit to industry. This is lent against the collateral constituted by firms’ inventories of raw materials, final products and work-in-progress. Though this can involve provision of credit in relatively large volumes, with significant income and credit risk and a degree of illiquidity, it implies a lower degree of maturity and liquidity mismatch than lending for capital investment. This makes traditional commercial banks less suited to lending for capital investment.

 To cover the shortfall in funds required for long-term investment, developing countries need to and have created development banks with the mandate to provide long-term credit at terms that render such investment sustainable. They tend to lend not only for working capital purposes, but to finance long-term investment as well, including in capital-intensive sectors. Having lent long, they are very often willing to lend more in the future. Since such lending often leads to higher than normal debt to equity ratios, development banks to safeguard their resources closely monitor the activities of the firms they lend to, resulting in a special form of “relationship banking”.

Often this involves nominating directors on the boards of companies who then have an insider’s view of the functioning and finances of the companies involved. In case of any signs of errors in decision-making or operational shortcomings, corrective action can be undertaken early. Since very often lending begins at the stage of the formulation of project itself, development banks are also involved in decisions such as choice of technology, scale and location. This require more than just financial expertise, so that development banking institutions build a team of technical, financial and managerial experts, who are involved in the decisions related to lending and therefore to the nature of the investment. This close involvement makes it possible for these institutions to invest in equity as well, resulting in them adopting the unconventional practice of investment in equity in firms they are exposed to as lenders.

This would in other circumstances be considered an inappropriate practice, since it could encourage development banks to continue lending to insolvent institutions since they are investors in the firms concerned and may suffer significant losses due to closure. Given their potential role as equity investors, development banks provide merchant banking services to firms they lend to, taking firms to market to mobilise equity capital by underwriting equity issues. If the issue is not fully subscribed the shares would devolve on the underwriter, increasing the equity exposure of the bank.

Firms using these services benefit from the reputation of the development bank and from the trust that comes from the belief of individual and small investors that the banks would safeguard their investment by monitoring the firms concerned on their behalf as well. Development banks can help monitor corporate governance and performance on behalf of all stakeholders, reducing their dependence of systems of indirect monitoring resulting from the discipline exerted by the threat of takeover in stock markets ostensibly prevalent in developed countries like the US and the UK. The effectiveness of the latter option is limited. Moreover, it is not available in most developing countries where equity markets are poorly developed and most firms are not listed.

Thus, development banks lend and invest. They leverage lending to influence investment decisions and monitor the performance of borrowers. They undertake entrepreneurial functions, such as determining the scale of investment, the choice of technology and the markets to be targeted by industry, and extension functions, such as offering technical support. Stated otherwise, they are a component of the financial structure that can ensure that lending leads to productive investment that accelerates growth and makes such lending sustainable.

In practice, development banks may not always leverage their capital-provision role to intervene effectively in management in all contexts. In some countries such as India, despite a significant role as providers of finance, development banks adopted a passive role with respect to technological or managerial decisions of private borrowers, avoiding a role that such institutions are expected to play. But this is not a characteristic of development banking, but evidence of an opportunity missed, not only to exploit the economies of scale associated with investment in knowledge skills of certain kinds, but also to coordinate investment decisions in systems dominated by private decision-making.

Saturday, 02nd Apr 2016, 10:26:25 AM

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