Return of the Native – The Cry for DFIs

What goes up, comes down! Over the last 2-3 years, there have been calls to resurrect development finance in India, associated with the post-independence license-Raj India and getting displaced sometime in the late 1990s by ‘universal banking’, which simply meant commercial banks could themselves undertake what was then being done by development finance institutions (DFIs) – long-term lending. In the immediate aftermath of winning independence, we had Industrial Finance Corporation of India (IFCI), Industrial Development Bank of India (IDBI), The Industrial Credit and Investment Corporation of India (ICICI), all established to provide long-term funds to help create a strong foundation for industry and commerce. The most important factor recognized then for establishing such institutions was the scarcity of capital in the country. In a fundamental sense, creating capital was the most critical need and the fundamental principle underlying the creation of such institutions was this – credit creates capital. In this instance, it was the government creating claims on itself (by granting credit) and creating capital in future in the process.

Among the most visible shifts away from this was the corporatization and listing of IDBI, which later became IDBI Bank. ICICI was already listed. Development finance ceased to be specialist lexicon and became part of normal banking vocabulary. Commercial banks began lending longer than five years, which typically was the limit for long-term lending by commercial banks. Now there are calls for a return.

The pleas for a return to DFIs have come from more than quarter – from the corporate sector, former bankers including a former RBI Governor and even current ministers. What is intriguing is that this has been happening at a time when most banks are in a stagnant mode – people may recall also that over the same time and more, just one factor has dominated economic discussions in India – non-performing assets otherwise known as bad loans.

This specific context in which there have been renewed calls from the government and corporate sector for re-establishing development finance institutions (DFIs) is not very encouraging. One reason advanced is that Indian banks are bogged down by NPAs, which has drastically affected their ability to lend and the second is that banks don’t have long-term funds. While the first is a sad commentary on thinking as the scourge of NPAs plaguing Indian banks is not a recent phenomenon, the second point is facile and betrays a static perspective. Support however comes from very serious quarters. In an article titled “We need a bank for just long-term credit’, Dr C Rangarajan, former Governor, Reserve Bank of India and S Sridhar, former CMD of say “It is now well recognised that one of the critical issues facing the economy is the stressed loan assets of the banking system. As per available data, the gross non-performing loans (NPAs) of all commercial banks amounted to ₹6.5 lakh crore; that is 8.6 per cent of their aggregate loan book as at end of June 2016. The corresponding figures for the public sector banks are even more alarming. ‘Stressed’ assets i.e. NPAs plus restructured assets shown as standard in the books of the banks, stand at approximately ₹12 lakh crore i.e. 12.1 per cent of outstanding loans and advances. Some analysts have estimated total stressed assets ratio at over 16 per cent.

A fall out of the stressed assets situation is the decline in fresh lending. Bank lending to the corporate sector has contracted in absolute terms during 2016-17 by 5.2 per cent over the previous year as against a growth of 2.8 per cent in 2015-16. The decline in credit growth has affected both short term and long term credit. This may partly explain the steep fall in corporate investment, which at the height of our high growth period stood at 14 per cent of GDP.”

((https://www.thehindubusinessline.com/opinion/we-need-a-bank-just-for-long-term-credit/article21955514.ece1#)

They argue then it was perhaps premature to shut down DFIs! More than 20 years had passed since the winding down of DFIs and this is what we say. Equally important, this implicitly assumes that the reign of DFIs was free from the problems that are plaguing commercial banks today. In fact, the story of DFIs then was as sordid as is the story of commercial banks today.

Be that as it may, while so much is being made about the NPAs now, the situation was no different in the mid-1990s when there were large amounts of NPAs. Should you look up the print business media of those times, you will find this a staple discussion together with a discussion over the credibility of debt/credit rating, as many ratings took a tumble.

In an article titled ‘The severity of NPAs’ Harsh Vardhan and Rajeshwari Sengupta argue in The Mint (May 30, 2017) that the correct way to measure the severity of NPAs is to relate them to capital instead of to GDP or Gross loans, as it is the size of capital that can cushion NPAs and keep the credit flow going. In their own words, “A high level of NPAs in the banking sector need not necessarily create a crisis situation, if the banks have the capital needed to provision for the losses”. While there can be a debate over this, my purpose is to refer to the NPAs in the 1990s. To continue with Mint, “To understand the importance of the NPA to capital ratio, we compare the depth of the NPA problem across two banking crisis episodes in India. The banking sector had witnessed an NPA crisis in the mid to late 1990s. The surge in bank NPAs at that time took place in the aftermath of the introduction of robust income recognition and asset classification norms which exposed two decades of bad loans. The NPA to loans ratio suggests that the current crisis is considerably less severe than that of the late 1990s. However, when NPAs are measured in relation to bank capital, the current crisis looks just as bad. In particular, the deterioration in the balance sheets of banks post-2010 is much sharper when measured using the NPA to capital ratio”. As they elaborate, banks’ capital grew greater than NPAs in the 1990s (thanks to recapitalization) but that is not the current situation. (https://www.livemint.com/Opinion/8ISpQAo5B5Twan0fkPw46J/The-severity-of-the-NPA-crisis.html).

NPAs periodically keep raising their heads leading to fundamental questions to be asked but aren’t. Is there a basic flaw in the Indian economy has been managed? To be fair, the same question can be asked of the world itself as no country has been free from NPAs. At least, we are in global company! My point is simple. There were NPAs then and now. Whatever the measure you choose to assess the severity of NPAs, their recurrence cannot be wished away. Which brings us back to the question posed earlier – why should a bank of long-term credit be immune to NPAs?

Misplaced hopes

What is not asked said here but is in fact the most critical question – why will the fate of the new DFIs be any different? The point is not that we need a bank for long-term credit but that we have failed to create a market for long term funds. Why is there a belief that a revival of development finance institutions now will make a positive impact? What is the problem plaguing the Indian economy that can be overcome through such DFIs? Assuming that this is done, where will such DFIs raise funds from? Let us recall that the multiple institutions set up for infrastructure have all been disasters. Some have disappeared, some have moved on to mainstream lending, and some have been caught in a complex web of structuring of their own making (which is a vehicle to hide and not really do something concrete). Even the sector specific institutions have landed up in serious trouble. Readers may recall discussions surrounding NHAI (National Highways Authority of India).

Development finance then and now

For those brought up on India as an emergent economy, DFIs might seem an anachronism, while the generation born before the 1990s might well recall them with contempt and distaste. The current generation would not even know what these were unless they have been students of economics. Let us refer to this explanation: “DFIs were started by the government to give sector-specific loans to various sectors- industry, agriculture, housing, infrastructure, export finance etc. The first DFI was the Industrial Financial Corporation of India (IFC) that was launched in 1948. The IDBI, UTI, NABARD, EXIM Bank, SIDBI, NHB, IIFCL etc are the other major DFIs. Later several of them were converted into banks as industry got opportunity to avail funds from the capital market (equity and debt) with the development of the capital market.”

(https://lms.indianeconomy.net/glossary/development-financial-institutions-dfis/

It is important to understand that there is a huge difference between development then and now. While there are of course many factors, the single most important factor is the dramatic rise in the scale of operations in most industries. There is of course greater competition, entry of foreign companies, a large variety of products and services, ecommerce, two stock markets, and so on. The earlier DFIs funded basic industries such as iron & steel, cement, etc. In fact, some DFIs such as IFCI funded only specific businesses. Their position was no better than banks today – they too had large losses.

Why should DFIs work now when a plethora of financial institutions set up specifically for infrastructure haven’t?   Each of the institutions set up for infrastructure didn’t really do much. One, in fact, went completely away into regular commercial bank and mutual fund. The question is not whether we need DFIs. That is not the correct question to ask. The question is why we have failed to create a market for long term funds (read debt). In the 1980s and into the 90s, one man skillfully raised funds in a series of tranches to fund a massive and continuous expansion – the late Mr Dhirubai Ambani. The question to ask is why the corporate debt market has ceased to flourish as it did once, not long ago. Naturally, bulk of the lending has had to come from commercial banks. The difference between NPAs now and the mid-1990 is the sheer size of average failure.

Arguably, the most important factor for this is the increased scale of operations arising out of the process of economic liberalization when there was a rise in the scale of almost all businesses. Add to that the fact that many business groups got into multiple businesses simultaneously not all of which were immediately productive of positive cash flows. And some were in businesses such as steel which saw a global decline. Not surprisingly, many of them landed in serious trouble leading to NPAs. Larger scale of businesses simply led to larger NPAs. It is really so simple. Incidentally, the corollary to this is how many companies in the Indian corporate sector have the managerial ability to effectively deal with large scale. But that is a different story.

Takeaways

Reasons furnished for the return of DFIs are not convincing

No lessons learnt from the failure of plethora of infrastructure institutions

The problem of the lack of a market for really long term funds has still to be addressed

The extensive use of