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Insights into Editorial: Financing reindustrialization: bring back development banks

Insights into Editorial: Financing reindustrialization: bring back development banks

Context in view of Commercial banks:

Many commercial banks in India are under financial stress. This has imparted a fragility to the banking system as a whole. Scams and scandals surface from time to time, making headline news. There is also a quiet crisis that runs deep. It is not audible yet. But it is mounting, since recurring failures of regulation or governance have not led to any accountability or corrective action. If the problem continues to be neglected, a trust deficit could develop over time.

Roots of the Problem of Financial Stress:

The fundamental problem is the non-performing assets (NPAs) of commercial banks. An asset becomes non-performing when it ceases to yield any interest or income for the bank. It is a bad loan. Such NPAs are rising rapidly. This rise is partly a consequence of the far more rigorous asset quality review by the Reserve Bank of India (RBI) based on its income-recognition and asset-classification norms.

The NPAs in the Indian banking system posing a threat to the stability of the country’s financial system and the economy. India has been ranked fifth on the list of countries with the highest Non-Performing Assets (NPAs), by CARE Ratings.


Reports and Data from RBI:

The RBI financial stability report shows that for all commercial banks, gross NPAs as a proportion of total assets were 9.6% in March 2017 and an estimated 10.8% in March 2018. For public sector banks, these proportions were higher at 11.4% and 14.5%, respectively. The problem is obviously serious in public sector banks. Even if private sector banks fare better, they also have the same problem. Hence privatization is no solution.

The systemic problem of bad loans needs to be addressed.


Factors for Piling up of NPA’s:

The underlying factors are common. Lending at political behest plagues public sector banks but private sector banks are not immune either. Lending could be driven by corrupt behaviour if bank managers collude with corporate borrowers to collect margins for themselves without assessing risk before extending bad loans.

Apart from behest, corrupt or inept lending, some systemic problems arose. Commercial banks simply did not have the capability to assess credit risk on long-term investment lending because they have always been engaged in advancing short-term working capital.

Moreover, commercial banks were caught in a maturity mismatch, because they borrowed short from depositors but had to lend long to investors.

Development Finance Institutions (DFIs):

Until the early 2000s, development finance institutions (DFIs) had done much of the lending to corporate entities for investment in the manufacturing or services sectors. These began winding down in 2000 and were closed down in 2005. Then borrowing from commercial banks emerged as an important alternative source of corporate financing.

India was a pioneer in establishing DFIs, its equivalent of development banks to kick-start industrialization.

There were three components in this process:

  • Long-term-lending institutions that were nationwide,
  • Institutions for the states, and
  • Investment institutions.


  1. The term-lending institutions were the Industrial Finance Corporation of India (IFCI), Industrial Credit and Investment Corporation of India (ICICI), and Industrial Development Bank of India (IDBI).The essential objective of these national institutions was to provide long-term finance for private investment in the industrial sector, with funds from the Central government and RBI on concessional terms.


  1. State financial corporations (SFCs) and state industrial development corporations (SIDCs) were set up to provide long-term finance for small and medium enterprises in the manufacturing sector of respective states, with funds from their respective governments on concessional terms.


  1. The third component, investment institutions, was unusual in this role. It was made up of Life Insurance Corporation of India (LIC), Unit Trust of India (UTI) and General Insurance Corporation of India (GIC). These institutions raised finances by mobilizing the savings of households, by spreading insurance habits, and by opening up avenues of higher returns on the financial savings of individuals.

Obviously, their sources of finance, either households or individuals, were mostly small savers. The provision of long-term development finance, in the form of loans or equity, emerged as a secondary objective for these institutions.


Retrospection of DFI’s:

It is clear that these DFIs made a significant contribution to the provision of industrial finance in India. As a proportion of gross fixed capital formation in the manufacturing sector, their total disbursements rose from one-tenth in 1970-71 to half in 2000-01.

In the absence of these institutions, such levels of private investment in the industrial sector would have been difficult to finance from alternative sources. It shows that their contribution was essential. Some of it served a strategic purpose in kick-starting manufacturing sector activities and supporting innovative lending to an emerging services sector.

Sometimes, the process of due diligence for extending loans was limited or incomplete. On occasions, even the debt servicing capacity of the borrower was not reviewed or monitored after the loan had been provided.

In addition, there were errors of omission. Infrastructure was excluded from their portfolios. By the time this was corrected, it was too little, too late. There was almost no coordination between their lending and industrial policy objectives, so there was no preferred access for pharmaceuticals, clothing, two-wheelers, auto components or information technology.


Development Banks:

The role of development banks was diluted during the early 2000s, not only in India but also in other developing countries. This was attributable to the progressive withdrawal of concessional funds made available by governments, which in turn was an integral part of deregulation and reform in the financial sector almost everywhere.

The China Development Bank was established as late as 1994, and it performed a critical role in the industrialization surge that began in the mid-1990s. Between 2000 and 2010, the outstanding loans of development banks as a percentage of gross domestic product dropped from 7.4% to 0.8% in India, but rose from 6.4% to 9.7% in Brazil and 6.2% to 11.2% in China, and declined from 8.6% to 6.8% in Korea, while this proportion rose from 8.5% to 15.9% in Germany and from 3% to 7.2% in Japan.


Reforms Needed:

The shortcomings of DFIs in India, highlighted above, obviously needed correctives. But their shutdown was a serious mistake, because their role was necessary and could not be dispensed with. It simply passed on the burden to commercial banks, not equipped for the task, which have accumulated NPAs as a consequence.

Need to be mindful implementation of the 4 R’s —

  • ‘Recognition’ of assets close to their true value
  • ‘Recapitalisation’ or infusion of equity for banks to protect their capital
  • ‘Resolution’ in the form of selling underlying stressed assets
  • ‘Reform’, through the right future incentives for the private sector and corporates to ensure there is no repeat of the twin balance sheet syndrome.


Way forward to reindustrialize India:

The time has come to establish a National Development Bank (NDB) in India. Such a new institution would start with a clean slate, without any baggage from the past. It must incorporate lessons from our past experience with DFIs to eliminate errors of omission and commission.

It is just as important to introduce institutional control mechanisms that were missing from the conception and design of the erstwhile DFIs.

Thus, it is essential to have an institutionalized system of checks and balances that can prevent collusion between governments and firms, or between development banks and firms, to capture rents by imposing discipline on the self-seeking behaviour of any one stakeholder, or even two stakeholders who wish to collude, by other stakeholders. The design and blueprint will need careful thought.

At this juncture, an NDB is both necessary and desirable. It would help reindustrialize India. It would also de-stress commercial banks.

Policymakers should set suitable incentives and allow independent banks to pursue efficiency in that setting, not meddle in their functioning through action-specific regulations. Therein lies the essence of second generation reforms in Indian banking.

The rot in the Indian banking system is deep but it can be treated. Unless the measures suggested are implemented effectively, the banking system would continue to burn cash for the politicians, bureaucrats, and businessmen. And the people of India, including the poorest of the poor would continue to pay the price.

Banks operational risk management, risk culture, internal control frameworks and external audit function should typically play a central role in preventing fraud.