FINANCE FORUM 2 004

1. FINANCE FORUM 2004 Development Finance Institutions (DFIs): Types, Role and Lessons A presentation by Khalid Siraj Washington DC, September 22, 2004

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

3. 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

4. 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

5. 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).

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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.)

17. 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

18. 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)

19. 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

20. 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 liaisonand understandingwith government policy makers

21. 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 capabilities of the participating FIs

22. 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

23. 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) USExport-Import Bank Canada Business Development Bank of Canada Canada Mortgage and Housing Corporation Farm Credit Corporation

24. 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 CommonwealthDevelopment Corporation (CDC) Germany Deutsche Genossenschaftsbank (DG Bank) Kreditanstalt fur Wiederaufbau (KfW) DeutscheAusgleichsbank (DtA)

25. 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

26. 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

27. 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

28. 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 US$50 billion

29. 4. Lessons (Contd.) • Collaboration with privatesector 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

30. 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

31. 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

32. 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.

33. 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

34. Thank you