Development banks in a new avatar?

The WLTF banks need to be institutions in search of a new business model to take care of an old need of the Indian economy

The Reserve Bank of India (RBI) has released an important and timely discussion paper on April 4, 2017, on the “wholesale and long-term finance” (WLTF) banks. The genesis of WLTF banks can be traced in the Nachiket Mor Committee report of June 2014 that envisaged a class of differentiated banks called “wholesale banks”. Taking a cue from the Mor Committee report and looking into cross-country experience, the present RBI proposal extends that vision of WLTF banks that would focus primarily on “lending to infrastructure sector and small, medium and corporate businesses” and “will also mobilise liquidity for banks and financial institutions directly originating priority sector assets, through securitisation of such assets and actively dealing in them as market makers”.

How different are these WLTF banks from the existing commercial banks? Apart from the specialised domain of activities, some of their proposed features may be worth noting. First, primary sources of funds for WLTF banks could be a combination of “term deposits, debt/equity capital raised from primary market issues or private placement, and term borrowings from banks and other financial institutions”. Second, these banks may be permitted to accept deposits only “above a large threshold amount” and are expected to have negligible retail segment exposure. Third, these banks are expected to have a higher level of initial minimum paid-up equity capital, say ~1,000 crore or more. Finally, some relaxation in respect of prudential norms on liquidity risk (e.g. liquidity coverage ratio/net stable funding ratio) may be considered for WLTF banks. Opening of rural and semi-urban branches and compliance to priority sector lending norms would not be mandated for these banks.

But why does a country need WLTF banks? Why are commercial banks unable to do what a WLTF does? More importantly, are these reincarnations of the erstwhile development banks? In this context, it may be useful to get a historical perspective of India’s development banks. India’s first development bank, the Industrial Finance Corporation of India (IFCI), was set up in 1948. Within the next five years, a number of state governments with the encouragement of the central government set up their own State Financial Corporations (SFCs). The Industrial Credit and Investment Corporation of India (ICICI) was floated as a public limited company with initiatives of the World Bank, the government of India and representatives of Indian industry. While the primary objective of the then ICICI was to provide mediumterm and long-term project financing to Indian businesses, it emerged as the major source of foreign currency loans to Indian industry. Subsequently in 1964, the Industrial Development Bank of India (IDBI) was set up as an apex institution in the sphere of medium- and long-term finance. It took over the business of the Refinance Corporation for Industry, which was set up in 1958 for SFCs. The control of the IFCI was transferred to the IDBI from the central government. The IDBI was constituted as a wholly-owned subsidiary of the RBI and the RBI has created a new long-term fund known as the National Industrial Credit (Long-term Operations) Fund with an initial contribution of ~10 crore to which the RBI used to make annual allocations out of its surplus profits before these were transferred to the government.

One of the key outcomes of the financial sector reforms in India has been the demise of the so-called development banks. This was in line with the report of the Narasimham Committee II, which recommended that the IDBI should be corporatised and converted into a joint stock company under the Companies Act on the lines of ICICI, IFCI and IDBI. Development banks were wound up in India primarily due to lack of sources of non-concessional finance which in turn emanated from a binding fiscal constraint. Put simply, the sources of finance for these development banks dried up. Accordingly, the IDBI Bank and ICICI Bank were born in their current avatars of universal bank.

After a decade of the demise of development banks, there is a view that while winding up the development banks, India policy-makers could have committed the folly of throwing the baby out with the bathwater. After all, the death of development banks created a vacuum in term and infrastructure financing. In an economy with well-developed financial markets, private corporate bonds could have come up in this space. But despite various attempts, the corporate bond market in India remained largely a private placement market catering primarily to blue-chip corporates. Thus, commercial banks had to come up to fill this vacuum. But commercial banks have typically short-term deposits as their main source of funds; hence any exposure to long-term lending created a serious assetliability mismatch in their balance sheet.

Long-term loan to infrastructure is a major issue here. Are commercial banks capable of catering to this segment? A disturbing trend in this context is the high exposure to long-term infrastructure lending that emerged as key source of accumulation of non-performing assets (NPAs). NPAs are anticipated to rise to 10.2 per cent of the aggregate assets of commercial banks in India by March 2018. Besides, the stress tests reported in RBI’s Financial Stability Report of June 2017 indicated that a severe shock to NPAs could considerably impact the profitability of banks. In such a situation WLTF banks seem to be the right solution.

Globally, there are instances of a number of successful specialised banks that cater to long-term finance. RBI’s discussion paper rightly cited the successful instances of wholesale and development banks in countries such as Brazil, South Korea and Japan. When commercial banks in India are burdened with NPAs and at the same time have huge infrastructural needs, the proposal to set up WLTF banks is really apposite at the current juncture. However, it will not be appropriate to treat these WLTF banks as a reincarnation of erstwhile development banks — they need to be new institutions in search of a new business model to take care of an old need of the Indian economy. Going forward, our economy cannot afford their failure.