Transcript Document 7403524

FINANCE FORUM 2004
Development Finance Institutions (DFIs): Types, Role and
Lessons
A presentation by
Khalid Siraj
Washington DC,
September 22, 2004
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/facilitated 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
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approach suited them
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 longerterm 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
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syndrome”, etc.)
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
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Close liaison and understanding with government policy makers
3.2 Experience of Second-Tier
Institutions/Facilities 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
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capabilities of the participating FIs
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
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vehicles were not very effective
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
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Farm Credit Corporation
3.3 Experience (Contd.)
France
Bank for Development of Small and Medium Enterprises
(BDPME)
Societe de Development Regional
Credit Foncier de France
Compagnie d’Assurance Credit A I’Exportation (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 25
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
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US$50 billion
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 Foundation’s 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 stateowned, 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
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