FINANCE FORUM 2004

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FINANCE FORUM 2004

• Development Finance Institutions (DFIs) Types,
  Role and Lessons
• A presentation by
• Khalid Siraj
• Washington DC,
• September 22, 2004

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Outline

• Scope of Discussion
• Types of DFIs
• The Experience
• Lessons for the Future
• Concluding Remarks

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1. Scope of Discussion

• The focus of this discussion is on state
  intervention in credit market to fill a perceived
  gap/market failure
• In this discussion, the term DFI is used in a
  broader sense meaning a vehicle, in the form of
  either a dedicated institution, unit, fund, or
  facility, that supports a certain economic
  development objective/(s) through preferential
  provision of financing and non-financing services

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2. Types of DFIs

• DFIs come in various shapes and forms and
  different combinations thereof. Some sweeping
  generalizations have been made
• Institutionally and operationally, they can be
  divided broadly in four categories
• Specialized Retailing Institution A separate
  entity or facility dedicated to promoting certain
  development objectives by directly assisting its
  customers
• Second-Tier Institution/Facility A separate
  entity or a facility that provides wholesale
  funding to financial intermediaries (FIs) for
  retailing to their customers
• Lines of Credit (LOC) Funding provided/facilitate
  d by state (directly or indirectly) to certain
  FIs for retailing to their customers
• Regional Bank Set up by a group of countries to
  serve their development needs (AfDB, IADB, EAB,
  BOAD)
• As Regional Banks are not a direct intervention
  in domestic credit market they are outside the
  scope of this discussion

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2. Types (Contd.)

• DFI models can also be categorized by (a) sectors
  they serve (agriculture, SMEs, exports, regional
  development, infrastructure, municipal finance,
  etc.) and (b) ownership (state owned, private,
  state/private partnership).

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2.1 Specialized Retailing Institutions

• The oldest and most traditional form of DFI that
  evolved mainly after World War II
• Many newly independent countries created
  specialized financial institutions to provide
  longer-term funding for industrial projects
  (e.g., Chile, Ethiopia, Turkey, India, etc.)
• Subsequently, they were also created to serve
  other sectors (agriculture, SMEs, infrastructure,
  exports, housing, etc.)
• Mostly created by state with or without private
  sector participation
• Up to 1968 WBG supported only private DFIs and
  then the policy changed to also support
  state-owned institutions
• In some countries (mostly LAC) special trust
  funds were created to perform the same functions

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2.1 Specialized (Contd.)

• The rationale for these DFIs was derived
  initially from the following considerations
• A narrow base of financial systems that
  concentrated mainly on simple commercial banking
  not interested in project financing
• Some regulatory restrictions on long-term lending
• Shortage of long-term resources
• Under-developed state of capital market
• The perceived need to support and accelerate
  industrial development immediately
• Negligible flow of FDI
• Encouragement from multilateral financing
  institutions as this approach suited them

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2.1 Specialized (Contd.)

• Therefore their objectives were to promote
  development of the designated sector/(s) through
  provision of term finance along with
  non-financial support (technical assistance in
  project formulation, implementation and
  management, development of backward regions,
  promotion of foreign investment, introduction of
  new entrepreneurs, capital market development
  through their equity investment operations, etc.)
• Typically these institutions obtained their
  resources from government or other official
  sources with little self-generated resources
• They borrowed and lent mainly in foreign exchange
• Generally, they offered single products, i.e.,
  long-term loans. Some equity financing was also
  offered but insignificant in relation to loans

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2.2 Second-Tier Institutions/Facilities

• In 1960s, some countries (especially large)
  realized the need to widen the net of credit
  intervention mainly to cater to the needs of
  relatively short-term funding needs of
  agriculture sector
• Also with the growth of their financial sector
  (greater competition and depth) it was felt that
  credit, both short- and long-term, could be
  channeled to priority sectors through non
  specialized FIs as well
• The main rationale for this approach was that the
  mainstream FIs needed to be encouraged to serve
  the needs of priority sectors and that this could
  be achieved by giving them access to funding on
  attractive terms (longer maturity and in many
  cases at subsidized cost). This was particularly
  considered necessary to promote availability of
  longer-term financing because most FIs had access
  to only short-term deposits

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2.2 Second-Tier (Contd.)

• Generally, their functions were
• Providing liquidity with appropriate maturity and
  invariably at subsidized cost (less than market)
• Imparting project financing skills (preparation,
  implementation and management)
• Providing training in project financing and
  management
• Improving the quality of the portfolios of FIs
  through diversification and better project
  selection
• Providing incentive to a larger set of FIs to
  increase voluntarily the flow of resources
  towards priority sectors

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2.2 Second-Tier (Contd.)

• This approach took the form of (a) a separate
  legal entity or (b) a trust fund or facility
  mostly housed in the central bank of the country
• An advantage of this approach was that the
  Second-Tier Facility operated with minimal
  organizational cost and very low default by FIs
  as mostly managers (central banks) of this
  facility had sweeping collection powers.
• In most cases, eligibility criteria were set for
  participating FIs. There are many cases of a
  flexible application of eligibility criteria
  especially for their continued compliance

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2.3 Lines of Credit (LOC)

• To a large extent LOC are very similar to
  Second-Tier Institutions/Facilities but have one
  basic distinction There
• is no wholesaler of funds
• Basically, this model served the business
  objectives of MDBs
• (WBG, ADB, IADB, etc.) who provided LOC to
• certain FIs against state guarantees
• Funds are provided for specific sectors or
  general investment
• purposes
• The FIs might be pre-selected or might join at a
  later stage by
• complying with eligibility criteria
• The underlying rationale of this approach was
  that local FIs
• lacked appropriate funding as well as managerial
  and technical
• capabilities for project financing and that an
  LOC could be an effective vehicle to fill this gap

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2.3 LOC (Contd.)

• Therefore, the most common objectives of LOC have
  been
• Enhancing project financing capabilities of FIs
• Providing long-term resources necessary for
  project financing
• Causing a demonstration effect for the other FIs
  to emulate
• Encouraging participating FIs to be
  self-sustaining in the business of project
  financing

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3. The Experience

• State interventions through DFIs generated in
  many cases substantial
• investment in the priority sectors, but their
  cost effectiveness and
• sustainability remain big questions
• There has been no systematic review of the cost
  effectiveness and
• sustainability of DFIs
• An attempt is made here to present a view on
  experience based on global experience

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3.1 The Experience of Specialized Retailing
Institutions

• After an initial successful start, Specialized
  DFIs started to suffer major setbacks in late
  1970s and early 1980s
• During this period, by one count over 70
  countries experienced serious distress in their
  specialized DFI sector because of a unsustainable
  high level of loan repayment defaults by their
  borrowers

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3.1 Experience (Contd.)

• Some of the major factors contributing to this
  distress were
• Macroeconomic shocks in late 1970s and early
  1980s coupled with major economic stabilization
  and liberalization programs radically changed the
  business environment for DFIs and their customers
  (enhanced exposure to international competition,
  reduced tariffs, competition arising from
  financial liberalization, major exchange rate
  realignment, etc.)
• Generally, DFIs had financed projects that were
  viable only under protected environment
• The Specialized DFIs had their own serious
  weaknesses (weak management, absence of
  commercial orientation, lack of autonomy,
  political interference, poor technical skills,
  almost total reliance on officially provided
  resources, corruption, monopoly syndrome, etc.)

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3.1 Experience (Contd.)

• In most developing countries, the new economic
  environment affected adversely the entire
  financial sector, but DFIs were much more
  severely hit because of some structural flaws in
  their model
• An inherent tension between their
  social/developmental role and financial
  objectives
• The pressure to perform their developmental/social
  role and preferential access to certain funds
  pushed them towards commercially unviable
  business and situations of moral hazards
  (corruption, political patronage, unrealistic
  business policies)
• Higher cost of funds vis-à-vis deposit taking
  institutions
• Excessive exposure to a single product (long-term
  loans)
• Limited client relationship relative to a full
  service bank

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3.1 Experience (Contd.)

• A great majority of developing countries have had
  to restructure their DFIs (closures, mergers,
  restructuring, etc.)
• Even some developed countries had a similar
  experience (New Zealand, Japan)

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3.1 Experience (Contd.)

• State-owned DFIs that have remained in business
  either have had to be bailed out at a high fiscal
  cost (Brazil) or have remained dormant
  (Bangladesh, Nepal, Nigeria, Kenya, etc.)
• A 1989 OED study of DFIs based on 120 World Bank
  operations concluded that it cannot be said that
  the institutions studied have achieved
  sustainability in a broad sense
• Another indication of the failure of specialized
  DFIs is that World Bank lending to such
  institutions declined precipitously after 1970s

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3.1 Experience (Contd.)

• However, some DFIs have remained solvent and
  continue to play an important role (Ireland,
  India, Pakistan, Sri Lanka, Portugal, Thailand).
• Their common success factors include
• Private sector control and management with full
  autonomy and no corruption or political
  interference
• A high level of commercial orientation
• An enlightened and modern management with state
  of the art technical skills
• Continuity of management leadership
• Constant and quick adaptations to changing
  business environment. Almost all of them are now
  fully diversified and converted into universal
  banks with emphasis on project financing
• Close liaison and understanding with government
  policy makers

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3.2 Experience of Second-Tier Institutions/Facilit
ies and LOC

• An in depth assessment of such interventions is
  even more difficult in the absence of a proper
  study. Broad generalizations have to be made
  based on proxy data
• While a large amount of resources were disbursed
  through these vehicles, broadly speaking they
  have not succeeded in following respects
• The expected voluntary flow of resources to
  priority sectors did not materialize
• In some sectors such as infrastructure, even
  dedicated funds failed to be utilized (Sri,
  Lanka, Bangladesh)
• While the Second-Tier Institution were able to
  maintain a healthy portfolio, the participating
  FIs experienced a deterioration in the quality of
  their portfolio (NABARD, India)
• In many cases the quantum of subsidy was large
  and uncontrollable
• There was no noticeable enhancement in the
  project financing capabilities of the
  participating FIs

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3.2 Experience (Contd.)

• A recent OED study found that the outcome of such
  operations during FY92-03 (48 unsatisfactory by
  number and 55 by commitment) was much worse than
  the overall Bank average
• Over 40 of original commitments have had to be
  cancelled, twice the rate the Bank as a whole
• An earlier study (1999) had found that the
  disbursement lag for LOC was exceptionally high
  ranging between 57 and 69
• The above two points confirm that the flow of
  credit towards desired sectors was not impeded by
  non-availability of resources alone but by other
  factors that were not addressed
• The fact that Bank lending for such operations
  declined from 12-15 in FY79-83 to less than 2
  in FY02-03 is a strong indicator that these
  vehicles were not very effective

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3.3 Experience of Developed Countries

• Almost all developed countries have intervened
  in their financial markets through DFI type
  vehicles. In Europe, some were created after WWII
  as part of reconstruction strategies
• United States
• Federal Agricultural Mortgage Corporation (Farmer
  Mac)
• Federal Home Loan Mortgage Corporation (Freddie
  Mac)
• Federal National Mortgage Association (Fannie
  Mae)
• Overseas Private Investment Corporation (OPIC)
• US Export-Import Bank
• Canada
• Business Development Bank of Canada
• Canada Mortgage and Housing Corporation
• Farm Credit Corporation

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3.3 Experience (Contd.)

• France
• Bank for Development of Small and Medium
  Enterprises (BDPME)
• Societe de Development Regional
• Credit Foncier de France
• Compagnie dAssurance Credit A IExportation
  (COFACE)
• Credit National
• United Kingdom
• Export Credit Guaranty Department (ECGD)
• Small Firms Loan Guarantee Scheme
• Commonwealth Development Corporation (CDC)
• Germany
• Deutsche Genossenschaftsbank (DG Bank)
• Kreditanstalt fur Wiederaufbau (KfW)
• Deutsche Ausgleichsbank (DtA)

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3.3 Experience (Contd.)

• Overall, these institutions have been quite
  successful in achieving their objectives and have
  not experienced any major distress
• Their success factors include
• Absence of major macroeconomic shocks
• Full operational autonomy
• Highly professional management and staff
• Hard budget constraints
• Minimal and well defined subsidy
• Absence of political interference
• Constant monitoring of their role and periodic
  adjustments as warranted by changing environments

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4. Lessons for the Future

• There is a renewed interest in the DFI vehicle
  because the financial liberalization process in a
  large number of countries is perceived to have
  not delivered optimally the objectives of greater
  depth and diversification
• In 2001, Bank credit to private sector in
  developed countries averaged 97 of GDP while in
  Latin America (more developed than other regions)
  was only 30
• The ratio of private sector bonds outstanding was
  41 for developed countries and 8 for Latin
  America
• The stock market capitalization was 99 in
  developed countries and 27 for Latin America
• There are also noticeable inequalities in the
  flow of resources among various sectors of the
  economy (rural, SME, infrastructure)
• Flow of resources is inconsistent with State
  priorities
• Banks have money but they do not lend

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4. Lessons (Contd.)

• Broadly, governments have three non-mutually
  exclusive options
• Direct Intervention
• Push lending through state-owned banks, existing
  as well as new
• Use private sector vehicle with
  incentives/subsidies
• Indirect Intervention
• Improve enabling environment to attract
  investment in deprived/priority sectors

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4. Lessons (Contd.)

• Lending through state-owned banks is highly risky
  and expensive
• Invariably, they lack proper commercial
  orientation and appropriate governance structure
• The possibilities of political interference and
  corruption are high
• The tension between their developmental role and
  financial objectives could lead to either
  financial disasters or an insignificant scale of
  operations and impact
• This type of intervention was effective in some
  cases in the past, but the economic and business
  environment in most countries is now radically
  different from what they were in 1950s and 60s.
• A direct intervention runs the high risk of the
  dedicated entity acquiring its own constituency
  and organic life not easy to phase out when no
  more needed
• A recent Bank study of state-owned banks found
  that between 1992-02 the fiscal cost of
  supporting such banks in ECA was over US50
  billion

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4. Lessons (Contd.)

• Collaboration with private sector would require
  some subsidy, direct or indirect
• If subsidy is given it should be transparent,
  quantified, caped, and incentive based. Open
  ended subsidy could lead to major moral hazards
• Direct intervention via private sector route
  could be effective where the market failure is
  limited (e.g., long-term lending does not extend
  to some sectors)
• In a situation of large scale market failure a
  direct intervention may not succeed

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4. Lessons (Contd.)

• Normally, a market failure situation arises
  because agents of financial system perceive high
  risks associated with priority sector
  lending/investment.
• Risk perception should be addressed
• Merely enhancing the availability of resources
  will not address this problem (aspirin treatment)
• Liberalization process does not necessarily
  result in the reduction of risk perception, a
  function of various other factors, i.e., enabling
  environment

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4. Lessons (Contd.)

• There is a large scope for improving enabling
  environment
• Inefficiency and ineffectiveness of legal and
  judicial system and weak property rights continue
  to be major problems in most developing countries
• A persistent high level of government borrowing
  is crowding out private sector because banks
  prefer safer lending to government despite lower
  returns
• Availability of credit information is quite
  limited as 57 developing countries have no credit
  bureaus. In OECD countries credit registers cover
  43 borrowers out of every 1000 while this ratio
  is 0.4 in South Asia, 0.8 in Africa and 2 in ECA

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4. Lessons (Contd.)

• Heritage Foundations Banking/Finance Freedom
  Index shows that despite a major progress on
  liberalization of financial systems the creditors
  rights very much remained constrained (98
  countries have a rating of 3-5 versus 1 for OECD
  countries)
• Similarly, Euromoney index to Access to Finance
  (2002) shows that developing countries were far
  behind (71 countries with less than 60 rating)
  the developed countries (on average 90)
• The macro liberalization process has to permeate
  down to micro institutional level (licensing,
  registration, regulation, etc.)
• The adverse hang-over effects need to be
  addressed (financial crises, fears of political
  turmoil and nationalization, etc.)
• Infrastructure bottlenecks still persist (roads,
  ports, electricity, gas, etc.)
• In agriculture sector risks are much higher than
  in other commercial sectors due to risks of
  natural hazards, crop failures, wide market
  fluctuations.

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5. Concluding Remarks

• Improving enabling environment should be the
  first priority
• Direct intervention should be undertaken after a
  thorough and careful analysis of all risk factors
  which remain high
• If a DFI vehicle is considered necessary, whether
  private or state-owned, the subsidy should be
  transparent and caped, and its design should have
  an explicit sunset clause
• A development agency rather than a bank may be
  more appropriate. A development agency should be
  transparently funded out of budget and it should
  play a major role in improving enabling
  environment besides providing direct financial
  and non-financial assistance
• A development agency would be a better way of
  managing subsidies
• Capital market is a much better source of
  providing long-term funding requirements
  (particularly infrastructure and municipal
  finance) than banking system as is the case in
  developed countries

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Thank you