Development banks or development banking?
Development banks have a long history in Sri Lanka. The first one was set up on the advice of the World Bank in 1956 and it was named the Development Finance Corporation of Ceylon (DFCC).
Subsequently, in order to focus on Small and Medium Enterprise (SME) lending, the National Development Bank (NDB) was established in 1978 along with the Sri Lanka Export Development Board and Sri Lanka Export Credit Insurance Corporation (SLECIC). The intention was to support the SME sector through financing and creating domestic SME entrepreneurs with export potential. Both these development finance institutions were financially supported by the International Financial Institutions like the World Bank and Asian Development Bank (ADB) and later were supported by bilateral agencies like JICA, FMO and EU.
The objective of these two development financing agencies, DFCC and NDB was to provide long term capital for the corporate and SME sectors. As commercial banks failed to provide long term lending, both these institutions were set up to extend investment financing. Why couldn’t the commercial banks with an extensive branch network provide adequate long-term lending? One reason was the inability of the commercial banks to raise long term deposits. Most of the savings instruments (term deposits) are relatively short term i. e. less than three years. Therefore, for commercial banks, there is a maturity mismatch of funds. That means they raise funds on short term basis and have to lend long term. Therefore, there is a tendency for the commercial banks to be reluctant in providing long term loans. In addition, the cost of funds would be high and the long term lending would carry higher rates of interest not affordable by the SMEs. When enterprises borrow at high interest rates, they need to have high rates of return on their investments. They need to make high profits to cover up the operational and borrowing costs. The banks tend to lean towards larger and established entrepreneurs in more traditional sectors.
How does the banking sector raise long term capital?
There are ways of raising long term capital by banks. The banks have to issue long term savings instruments to mobilise funds from the public. If not, there are other sources of long term funds available in a country who can invest in long term instruments such as long term debentures. The contractual savings funds like provident funds, saving and insurance funds and pension funds have long term funds. The largest pool of resources available in the country is with the Employment Provident Fund (EPF) and the balance is with the National Savings Bank and the insurance companies. Most of these funds are managed by the state and according to statutory requirements in their respective Acts, majority of the funds need to be invested in government securities such as treasury bonds and treasury bills.
After all these are savings funds which belong to the people of the country mostly their retirement savings and need to be invested in safe financial instruments.
In addition to statutory requirements, in countries like Sri Lanka where governments have persistent budget deficits, the governments pre-empt the long term capital from these funds for government requirements. In any country, government securities are the safest instruments and less riskier investments. These are called guilt edged securities as they tend to be risk free, at least in theory.
When the budget deficits are high, government also offer higher interest rates to obtain public funds. In addition to being risk free, they also carry high interest rates.
Therefore, the government securities (i.e treasury bills and bonds) become more attractive for these contractual funds. However, when the governments borrow from these sources, they crowd out the private sector or in this instance the banking sector.
Why can’t the country borrow long term capital from foreign sources?
When a country is a least developed country or belong to the developing country category, the country has access to low cost funds from multilateral financial agencies like the World Bank and ADB. However with countries graduating from the least developed or developing country status the access to cheaper sources of funds start diminishing. That is the price a country has to pay for achieving its development. Why? When the country’s per capita income increases beyond a certain threshold and its poverty rates decline compared to the other comparator countries, in theory the country’s ability to raise its own funds for its expenses increases. Its ability to enhance national savings also increases. In addition, the country’s ability to borrow from other sources such as international money markets, commercial sources and also raise funds from multilateral sources at higher interest rates also increases. Concessionary funds are meant for least developed countries with higher poverty rates.
However, the reality is different. Governments, especially democratically elected governments with short election cycles, tend to use funds for unproductive activities.
Therefore, they continue to use long term sources like EPF funds crowding out the private sector. In such a scenario, blaming the banking sector for not extending long term capital at affordable rates is unfair. In addition, setting up new development banks would not help the private sector especially the SMEs. Therefore, the government needs to bring their budget deficits under control and allow the contractual savings institutions like the EPF, savings and insurance funds to invest in long term savings instruments which can be issued by the banking sector. They are also safer and less riskier.
It may not be feasible in the immediate future but in the meantime without setting up new development banks, the banking sector needs to introduce more innovative financial instruments. In addition, the banks also need to be encouraged to train and incentivise their staff on development banking.
Furthermore, the Government should refrain from providing subsidised credit to sustain inefficient enterprises. We have failed experiences of the SME Bank and Lankaputhra Bank to learn from. Need of the country at this moment is development banking and not more development banks.