Development Finance Institutions (DFIs)

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?

  1. 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.
  2. Such banks often lend at low and stable rates of interest to promote long-term investments with considerable social benefits.
  3. 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.
  4. Considering the social benefits of such investments, and uncertainties associated with them, development banks are often supported by governments or international institutions.
  5. 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.
  6. 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.
  7. The capital market complements commercial banks in providing long-term finance.
  8. IFCI, the Industrial Finance Corporation of India, was set up in 1949. This was probably India’s first development bank for financing industrial investments.
  9. 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.

  1. 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.
  2. After 1991, following the Narasimham Committee reports on financial sector reforms, development finance institutions were disbanded and got converted to commercial banks.
  3. 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:

  1. Power Finance Corporation Ltd (PFC),
  2. Indian Renewable Energy Development Agency (IREDA),
  3. National Housing Bank (NHB),
  4. Housing and Urban Development Corporation Ltd (HUDCO) etc.

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