DEVELOPMENT FINANCIAL INSTITUTIONS

1.1.1 Introduction:
Development Financial Institutions or Development banks are the
institutions which supply capital, knowledge, and enterprise, the three
major ingredients of development for business enterprises. These
Institutions provide long term finance to agriculture, industries, trade,
transport and basic infrastructure, so that in the absence of financial
resources the economic development of the country is not adversely
affected. These institutions have been taking interest in industrial
finance to industrial sectors as well as promotional development
activities of the industrial units in the country .

William Diamond defines Development Financial Institutions as “an

institution to

promote and finance enterprises in the private sector.” It is important to

stress that the
development banks apart from financing development projects provide
supporting services too. These institutions provide finance, promote
industrial units, and underwrite securities of the companies and directly
invest in shares and debentures of the company. Technical and
managerial advice is also given by them.

1.1.2 Objectives:

(i)To provide various types of assistance like technical, managerial,

financial, and marketing and so on. To provide medium and long-term
credit at reasonable cost to aspiring entrepreneurs.

(ii)To develop over a period of time efficient managerial resources, to

help rapid development of the country.
(iii)To sub-serve the social goals, planned objectives, priorities and
targets at national planning level.

(iv)To allocate resources to high priority areas.

(v)To accelerate the growth of the economy

.
(vi)After the globalization process in the beginning of 90’s, development
banks diversified their services to almost each and every sector of the
economy.

(vii)In countries like India, sheer vastness of size necessitates

considerable attention to be paid to the objective of regional
development. In deployment of credit, development
banks pay adequate attention to the regional development objectives.

DFI‟s after post Financial Sector Reforms of 1990:

In India, the Development Financial Institutions were established and
developed by Government of India and Reserve Bank of India (RBI) to
meet the specific needs of the industry and were traditionally engaged in
long term financing, as their main objective was to take care of the
investment needs of industries and to contribute to a better industrial
climate. They had over the time, built up expertise in merchant banking,
project evaluation and also started giving working capital finance.
Recently, they were allowed to accept medium-term deposits within the
specified limits. Off late, financial institutions were also permitted to
combine their traditional activities with investment banking activities
with certain moderate restrictions. Most of the Financial Institutions
have floated banks, institutions and mutual fund subsidiaries. Ownership
changes took place, several institutions went public, and organization
structure itself got
transformed.
 IMPORTANT ACTIVITIES OF DFI‟s

DFI‟s
1 ) DFI’s granting Long-term Loans and Advances, Short-term Loans
and Advances, Working capital finance, Accepting term-deposits and
issuing Certificate of Deposits.
2) Underwriting and Subscribing directly to shares / bonds of corporate.
3) Commercial banking, Credit rating, Brokerage, Housing Finance,
Mutual funds, Project Consultancy, Registrar Services etc.

COMMERCIAL BANKS V/S DFI‟s

DFI’s were set up either under The Companies Act 1956, or as statutory
bodies under the acts of parliament. These are prudential requirements as
also entry conditions for banks under Banking Regulation Act 1949, for
undertaking banking business
Commercial Banks Development Financial
Institutions

1)Commercial banks Short term 1)Commercial banks Short term

finance. finance.

2)They undertake the Planning and 2)To promote growth and provide
Management of essential elements support they are going to
of banking. underwrite securities, invest in
Shares and Debentures of other
commercials.

3)Commercial banks accept 3)DFI’s provide capital, expertise

deposits and lend loans. and knowledge.

4)Banks are allowed to invest in 4)They have been allowed to

shares of private bodies and public invest partially into the deposit
sector undertakings of their market subject to limit related to
incremental deposits in the their net worth.
previous year.

5)Planning includes: 5)DFI’s provide all kinds of

assistance such as:
(i) Estimation of funds required.
(ii) Sources of finance and their (i) Medium to Long term credit at
proportion. reasonable cost.
(iii) Utilization of fund. (ii) Development of managerial
(iv) Control and monitoring the resources to priority areas.
Fund. (iii) Accelerating growth of the
 economy.
Sound planning helps banks in (iv) Adequate attention to regional
meeting its obligation of: development.
a) Statutory requirements. (v) Diversification to all fields
b) Assisting various sectors. after globalization.
c) Fulfilling Social obligations.

d) Maintaining efficiency and

profitability.
NEED FOR DFI‟s CONVERTING INTO BANKS

1. High cost of funds, which is over 12 percent in case of a financial

institution and just over 6 percent in case of a commercial bank.
2. Increasing competition, due to increase in various new players like
insurance companies, mutual fund entities etc.
3. Low demands for long term funds, due to absence of heavy project
investments especially in the area of infrastructure.
4. High level of non-performing assets.
5. Increasing competition from commercial banks in retail financial
market.
6. Lower spread due to extensive competition.
7. High competition in market to attract top rated borrowers at low.
8. The global financial services market is growing very fast and chains
of foreign banks are attacking traditional banks by offering new products
of loans and investment portfolios under one roof.
9. Liberalization and de-regulation of financial markets have led to
fragmentation of traditional branch services.
10. Information Technology development has paved the way for
excellent customer services by way of providing electronic distribution
channels. New breed of private sector banks and foreign banks are
providing a wide range of services under one roof.
11. Many foreign banks and new breed of private sector banks have
started outsourcing various products. For e.g. Credit cards, Insurance
products, etc.
12. Customers have become very demanding now. They want various
financial services including expert advice on investment and portfolio
management for longer hours. (24 hours, 365 days) and sometime in
their houses also.
13. Foreign banks and new private sector banks are integrating all its
customer information and making the information available across all
different delivery channels, i.e. their branches. Many other banks have
also realized that the data warehousing has the potential to play an
immensely important role in the future, especially in relation to how the
banks use their information with their virtually delivery channels.
CORPORATE VIEWS ON CONVERSION OF DFI’s INTO BANKS

Extinction of DFI‟s will affect Development of the Country

ICICI was the first to change colours followed by IDBI and now it is the
turn of IFCI. There is also talk of merging Industrial Investment Bank of
India (IIBI) with IDBI once the latter is converted into a bank. Anyway,
Industrial Investment Bank of India is a marginal player in development
financing.
With the concept of universal banking catching up, the DFIs have
decided to convert into banks. One of the main complaints of these DFIs
is that as they are not banks since they did not have access to cheap
finance by way of deposits from the public. But this was to an extent
made good by allowing them to issue tax-saving bonds.
If the DFI’s were burdened with huge NPAs it would be wrong to blame
the concept of development finance. It is more to do with wrong
selection of projects (usually due to political interference) than anything
else.
In India, the debt market is not fully developed nor is there any attempt
to develop one. Therefore, those who want to set up new projects have to
approach financial institutions for part-financing the projects.
Now the banks are more interested in retail banking as also home loan
financing. Though this mania has started only recently no one knows
where it will end. There is no guarantee that retail banking is the safest
way of employing banks funds. One will come to know its validity only
after the recovery process begins. Short duration of the borrowing period
is one reason for banks' craze for retail banking.
DFI’s have seen a premature end though their continuance was a
necessity, at least till India reached the growth levels of the South-East
Asian countries. The absence of DFIs will, therefore, hamper
development of the countries growth in the coming years
“Universal banking by DFIs: Handy, but no Solution to NPAs”

In the last few years, the most serious problem DFI’s had to encounter is
bad loans or Non-performing assets (NPAs). For DFIs, universal
banking or the installation of cutting-edge technology in operations are
unlikely to improve the situation concerning NPAs.
The improper use of DFI funds by project promoters, a sharp change in
operating environment and poor appraisals by DFIs combined to destroy
the viability of some projects. The NPAs of these projects have dented,
in varying degrees, the balance-sheets of the three DFIs.
ICICI seems to have suffered the least, mainly because size of its
balance-sheet size, which has grown by a compound annual growth rate
of 19.25 per cent over the last four years. At the same time, the
company's gross NPAs have grown by 21 per cent. Though the gross
NPAs grew faster than the balance-sheet, the combined effect of the
growth in the absolute size of the balance-sheet and accelerated
provisioning has brought down ICICI's net NPAs to 5.2 per cent of total
loan assets in 2000-01 from 6.8 per cent in 2006-07.
As the former RBI Governor, Mr. Bimal Jalan, suggested, universal
banking will not solve the NPA problem. Keeping aside the grey areas
that accompany the move to universal banks, DFIs seeking a merger
with a commercial bank makes sense. While the move may not solve the
NPA problem, it may mitigate the problem of competing in a market that
has players with a significantly lower cost of funds.
Universal banking no panacea for ill DFI‟s, says former RBI
Governor, Bimal Jalan

The Reserve Bank of India governor Bimal Jalan added a new

dimension to an ongoing debate by saying that the move towards
universal banking will not solve the problems of the Development
financial institutions (FIs).
“Universal banking will not provide a panacea for the weaknesses of an
FI or its liquidity and solvency problems,” Jalan said. He was addressing
bank chiefs at the Bank Economists Conference 2008, organised by
Allahabad Bank. He also said that universal banking cannot be the
escape route for FIs which have been suffering from operational
difficulties arising from under capitalisation, non-performing assets and
asset-liability mismatches.
Later, participating in a question-answer session, Jalan categorically said
universal banking is not the central bank’s prescription and neither has it
fixed any timeframe for the transition to the “so-called universal
banking’. “The overriding consideration should be the objectives and
strategic interests of the institutions concerned in the context of meeting
the varied needs of customers, subject to normal prudential norms
applicable to banks,” he said. From the regulatory point of view, the
movement towards universal banking should firmly entrench the
stability of the financial system and preserve the safety of public
deposits, he added.
Jalan’s views on universal banking are significant in the context of both,
the ICICI and the Industrial Development Bank of India (IDBI)
proposing to become universal banks. ICICI has already merged itself
with ICICI Bank and the integration process is expected to be wrapped
up by March 31. The IDBI, however, is yet to formalise its game plan.
Both the institutions suffer from asset-liability mismatches and IDBI’s
non-performing assets are still rising. Both the institutions have been
projecting that Universal banking is the only way to survive as far as
they are concerned.
DFIs and Risk
DFIs' mandate requires them to invest in areas commercial banks do not,
towards poorer countries and sectors and as hence they face higher risk.
DFIs must help markets grow and seek to improve the investment
climate, in order to demonstrate that enterprises can develop in
economically challenging markets, thus contributing to sustainable
development. However, since private capital must also be involved and
their continued investment in future projects ensured, a commercial
return must be achieved. Yet DFIs seek to resolve these two conflicting
factor through an 'optimum' level of risk by balancing the cost of
managing elevated levels of risk with the need to maintain liquidity
sufficient to ensure strong institutional credit ratings, a low cost of
borrowing, and generate a surplus to support technical assistance and
grants.
Experience might suggest DFIs have operated at an optimum, for
instance, during the Asian financial crisis of the late 1990s, portfolios
were riskier, loan losses higher and returns lower than they are at
present, but it did not adversely affect their institutional credit ratings
due to state backing. The EBRD argued it was able to weather the
impact of a major shock 3.5 times the size of the global financial crisis
triggered by the Asian financial crisis, using only accumulated reserves.
However, it does appear that DFIs were lowering their expose to risk
during the period leading up to the 2008 global financial crisis, capital
adequacy ratios were increasing, bad loan reserves decreasing and
portfolio shares in Africa were unstable.
2008 Global Financial Crisis
DFIs, however, cannot take on more risk without paying heed to
accessibility of credit in the wider international financial markets.
However, DFIs are less directly affected by the 2008 global financial
crisis, because of their mainly fixed rate loans and high levels of
liquidity. DFIs could thus play an important role in being the lender who
is not only the ‘first to enter’ a market, but also the ‘last to leave. This
may reduce the problems caused by herding behaviour of private capital
flows.
Development Financial Institutions…fulfilling the
need of the time

Specialised financial institutions addressing the gaps in the financial

system. ‰‰
Provision of medium and long-term financing for industrial projects;
carry higher credit risks and market risks.
Contribute to the development and growth of the targeted industries and
strategic sectors of the economy & thus national development.
Generally state-owned ; Little relevance in developed countries now. ‰
However, Europe had the benefit of Marshall Plan, Japan had
Reconstruction Finance Bank.
Well developed capital markets in developed countries.‰
Many developing countries did not have such special financing
mechanisms.

FINANCIAL MARKET DEVELOPMENT:

HAVE DFIs MADE A CONTRIBUTION?
One expectation of donors in supporting DFIs has been that these
institutions would contribute to strengthening financial markets in
developing countries. Regrettably, DFIs have done a poor job in
contributing to financial market development.
"Development finance institutions carry out programs that do not
substantially change, enrich or strengthen the financial infrastructure of
the country". This conclusion of a German Government review of DFI
programs is typical of evaluation by the World Bank , the Inter-
American Development Bank and A.I.D. Other donors have been only
marginally concerned with strengthening local financial markets.
Until recently, many donors entered into projects with DFIs
expecting these intermediaries to have a virtual monopoly over long-
term finance in developing countries. This assumption has proven false.
Instead, DFIs in many countries face increasing competition from
commercial banks, leasing companies, and other sources of long-term
and equity finance. In some lesser developed countries, particularly in
Africa, this situation is less common.
Financial policy measures have placed severe limits on the
ability of DFIs to offer new financial services, raise substantial local
resources, and help to develop local capital markets.
These measures have ranged from limits on short-term lending and
commercial paper operations, to controls on interest rates and on credit
allocation, to restrictions on competition between financial
intermediaries and on financial diversification.