development-finance-institutions-dfis-th

Context: The government is working on a strategy to give a fresh lease of life to so-called development finance institutions (DFIs) for funding infrastructure projects as rising non-performing assets in the banking sector — which dominated infrastructure funding — limits their heft and threatens to spoil ambitious infrastructure-building plans.

As a first step, the government has indicated its intent to modify India Infrastructure Finance Co Ltd (IIFCL) into a DFI by increasing its equity capital.

Analysis

What are development banks?

  • Development banks are financial institutions that provide long-term credit for capital-intensive investments spread over a long period and yielding low rates of return, such as urban infrastructure, mining and heavy industry, and irrigation systems. 
  • Such banks often lend at low and stable rates of interest to promote long-term investments with considerable social benefits. 
  • To lend for long term, development banks require correspondingly long-term sources of finance, usually obtained by issuing long-dated securities in capital market, subscribed by long-term savings institutions such as pension and life insurance funds and post office deposits. 
  • Considering the social benefits of such investments, and uncertainties associated with them, development banks are often supported by governments or international institutions. 
  • Such support can be in the form of tax incentives and administrative mandates for private sector banks and financial institutions to invest in securities issued by development banks.
  • Development banks are different from commercial banks which mobilise short- to medium-term deposits and lend for similar maturities to avoid a maturity mismatch — a potential cause for a bank’s liquidity and solvency. 
  • The capital market complements commercial banks in providing long-term finance. 
  • IFCI, the Industrial Finance Corporation of India, was set up in 1949. This was probably India’s first development bank for financing industrial investments.
  • In 1964, IDBI was set up as an apex body of all development finance institutions.
  • As the domestic saving rate was low, and capital market was absent, development finance institutions were financed by:
  • (i) lines of credit from the Reserve Bank of India (that is, some of its profits were channelled as long-term credit); and 
  • (ii) Statutory Liquidity Ratio bonds, into which commercial banks had to invest a proportion of their deposits. 
  • However, development banks got discredited for mounting non-performing assets, allegedly caused by politically motivated lending and inadequate professionalism in assessing investment projects for economic, technical and financial viability. 
  • After 1991, following the Narasimham Committee reports on financial sector reforms, development finance institutions were disbanded and got converted to commercial banks. 
  • The result was a steep fall in long-term credit from a tenure of 10-15 years to five years. 
  • Some of the existing central public sector DFIs, are: 
  • Power Finance Corporation Ltd (PFC), 
  • Indian Renewable Energy Development Agency (IREDA), 
  • National Housing Bank (NHB), 
  • Housing and Urban Development Corporation Ltd (HUDCO) etc.