Credit Spreads & Developmental Finance 

A noteworthy feature now being observed in many developing countries is with regard to the so-called developmental financing bodies or term-lending institutions. They are jettisoning their original mandate(s) and objectives to gradually convert themselves into full-fledged commercial banks; with a significant focus on retail finance. This is perhaps driven by both shareholder expectations following their flotation / privatisation, as well as by market forces that reward those in retail banking with far greater profit spreads, than those pursuing other financing opportunities. This is a little bit like trade finance scoring over project finance in the banking arena. Of course, these might well be comparison of apples and oranges. Trade finance tends to be at the shorter end of the tenor curve i.e. periods involving three to five years; excepting the case of personal / mortgage finance that may extend for longer periods. Developmental finance, on the other hand, typically, is to support growth and funding plans for industry, agriculture and infrastructure, and the requirements tend to be for medium to long term. Because the revenue-earning potential of these underlying projects / infrastructure is limited, and, in many instances, more in the nature of utilities or back-bone support to the economy, the profit / credit spreads in lending or investing in this sector, are not exciting. Besides, there is some amount of drudgery and costs involved, as these financing forms require detailed project and financial appraisals, and the funding required is enormous and may warrant a consortium approach. Therefore, developmental finance may clog up a financial institution’s balance sheet for many years, and, thus, not freeing it to pursue their businesses in an opportunistic manner; as and when they present themselves.

It is in this context, that those countries that previously had a socialist bent, such as India, China, many parts of Africa, Egypt and indeed, many developing countries, chose to establish dedicated developmental financial institutions. Here, the state held a sole or a large stake, and effectively worked with the promoters of large industrial projects and start-up ventures in establishing utilities, infrastructure and large industrial entities. Unfortunately, state ownership brings in its wake, its own invidious features in terms of inefficiency, political machinations and inappropriate allocation of resources.

Many of the senior executives of these developmental institutions were at the beck and call of their political masters in power. Whenever a nexus developed, especially in democracies, between those in the ruling party and those in the businesses, pressures began to be applied and were found difficult to withstand, as the boards of directors of financial institutions were packed with pliant persons with little grass-roots support and even less professionalism, credibility or standing. Even if they had good intentions, these were blocked by the bureaucracy, who interpreted the rules to rationalize the decisions made by those in positions of authority and influence.  Theoretically, developmental situations had the right raison d’etre but the actual situation petered into bad debts, cost over-runs, funding shortfalls, delay, and in many instances, compounding impending corporate and financial disasters.

The model of such developmental financial institutions was often derived from the Western world and Japan, be it the U.K.. Europe, North America and especially Canada. With good management as well as checks and balances, these organizations could have been run professionally and profitably. However, the non-shareholding stakeholders and beneficiaries in public enterprises are really the population segment of low income, but they cannot dictate the effectiveness of these organizations’ functions. Thus, the  vicious cycle.

The regulatory framework for developmental financial institutions is another constraint; albeit unintended, requiring large resources to set up the equity flows into the infrastructure sector that is governed by stringent regulations and firewalls. These do not encourage or enable more players to come in and arbitrage away. Thus the structures once created to protect, have by lack of competition, degenerated into a sure recipe for further accentuation of the problem.

It is in this context, that we should welcome the moves by China Construction Bank to emerge out of government ownership by way of a massive IPO for US$ 3 billion, and other state-owned entities in China, to approach the market. Similarly, the aspirations of ICICI Bank and The Industrial Development Bank of India to convert themselves into full-fledged commercial banks, have sharpened their focus. They are no longer either industrial or developmental, as their names and charters would suggest.  Instead they are cloning the likes of Citibank, launching forth with great fanfare into car loans, personal loans, credit cards, mortgages etc. where the margins are high and in many  instances, three to five times their cost of funds.

If this new syndrome is escalated, it could lead to further distortions. Credit card interest rates, globally, are not very transparent. When regarded as a portfolio, credit cards have low mortality rates. If large project lending by developmental institutions go sour  (such as Dabhol or the mini steel plants or the shipping firms in the past), the large developmental banks can come a cropper. Even on a risk-reward basis, institutions now prefer a quick turnaround of their portfolios in three to five years, rather than wait for ten and twelve years for reward or come-uppance.  The credit spreads are therefore perversely skewed and do not incentivize capital and lending to go where they are not needed.

Then where are the funds for long term projects going to come from? Many organizations at the para-statal level, such as the IMF, the World Bank, Asian Development Bank, EBRD, African Development Bank etc. should channel substantial ‘seed’ funds and find some ways of de-risking the residual risks; so that the commercial and the investment banks can bring up the slack, and “cherry-pick” profitable opportunities; even if this may sound a little inequitable. For creating such opportunities jointly, there can be some reward mechanisms for the para-statal agencies in terms of which the investment and commercial banks can invest in the former’s financing instruments and provide to them some form of global reserve requirements; similar to what central banks levy.

All taxes and levies are anathema to the markets, but we cannot have a ‘free for all’. Nor do we have an ‘open skies’ policy or liberal licensing regulations. If more financial institutions were allowed easy access to retail lending, credit card, investment and asset management segments (without going to such great lengths as of now,  to prove their credentials and capital adequacy), then market expansion and efficiency will force the profit margins to come down for the benefit of the consumers and the small  / personal borrowers. The moment the risk-reward issues are re-balanced and aligned in favour of customers, then retail lending and short-end activities will not supplant wholesale developmental finance and to the detriment of the society / community at large.   

 In capitalist governance, lack of level playing field will not help. Ultimately, this is the dilemma facing the policy planners. Even if a country has a very large service sector, its manufacturing, infrastructure and developmental activities may not produce huge margins, and yet they are necessary for the consumers and retail sectors to flourish and for the countries to make progress tangibly.  It is better that market mechanisms are restructured and the regulatory framework modified for these to be achieved. Or else the state will remain a clumsy and adhoc arbiter of the financial destinies. Its inefficient bear hug / embrace may suit the socialists but not all those in the financial sector.

The author is General Manager of Emirates Bank.  However, the views expressed in this article are not necessarily shared by the Bank. 

Posted on: 14.03.2004

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