The Hindu Business Line : Banking on development paradigm

If development banking is to regain its charm, it has to re-invent itself. These long-term lenders must learn to think differently, and should evolve a mechanism to assess the health of the borrower. Only a change in the mindset, a new vision, can give development banks a new life, says P. V. Indiresan.

DEVELOPMENT banks in India have had a chequered and not always a happy history. Some have managed to come back from the brink by taking to universal banking, or merging with a normal bank. In general, it may be said that development banking has lost its charm. So much so that when Ms Ranjana Kumar was shifted from the none-too-healthy Indian Bank to Nabard, a banking veteran said that she deserved not congratulations but commiseration.

Political interference and flawed industrial policy have been the main reasons why development banks have fared badly. At the same time, it needs to be said that some conceptual errors about the nature of development banking have made matters worse.

From the time of Independence, political interference in the functioning of banks has been both overt and covert. For instance, loan melas made many banks sick. Even now, many villagers think that a loan from a government bank is a gift; it need not be repaid. In spite of such impressive sounding institutions as Debt Recovery Tribunals, it is still difficult for banks to recover in full the amounts due; more often than not, banks have no option but write-off most of the dues. Periodic concessions to borrowers ordered by the Reserve Bank of India have made debt recovery quite difficult. In consequence, ill health has dogged the banks in India.

Though development banks did not have to suffer from loan melas, they too were subject to political pressure to fund projects of dubious value. For long years, there was no culture of financial closure; many projects started more with hope and hype than with calculated design, and with no clear idea of where the funds would be found to complete them. Even if the project had been well conceived, administrative delays made many projects unviable.

During the Licence Raj, getting a manufacturing licence was an end in itself. Licences were obtained or bought merely because they were there and not because they made economic sense. It was also possible to control a company by investing no more than a small fraction of the total cost. It was not uncommon in those days for not-so-scrupulous-businessmen to recover their entire investment by extracting commissions. There was no competition to enforce efficiency. Under such circumstances, the surprise is not that development banks performed badly but that they survived at all.

Notwithstanding these handicaps, development banks made the situation worse by a faulty appreciation of their role. Normally, bankers are cautious. They lend only to the wealthy who can offer safe and substantial collateral. Bankers are not ambitious: they are content charging a fixed interest even if the borrower makes a killing and multiples the investment several times. They also accept as normal the erosion of asset value by inflation.

Development banking is different: Loans are made not to those who have accumulated wealth in the past but to those who show promise to become wealthy in the future. Normal banking looks for safety in assets accumulated from the past; in development banking, possible accumulation of assets in the future is the true collateral. Thus, while in normal banking, the collateral is real and tangible, in development banking, the collateral is a dream; it is intangible. In normal banking, an interest default of more than 90 days becomes a non-performing asset. In the case of development, growth is rarely smooth; development happens in fits and starts; cash flows are subject to wild fluctuations and become negative at times.

Hence, development banks need to have a longer perspective than three months; they should show patience for years. Normal banks can afford to be myopic; development banks should take the long view. For development banks, it is the trend line and not the current surplus that is important. As one development banker blithely explained: "When I see any risk, I take my money and run away." But that is not development banking; development banks take risks that ordinary banks will not.

As a token of their support for progress, development banks offer an interest holiday for the gestation period, and then charge a suitably adjusted flat rate of interest. That does help new enterprises a little, but only a little. Interest holiday is too crude a device to help new enterprises that, being babies, suffer from unexpected (and periodic) teething problems.

There is some truth in the well-worn cliché that bankers lend when the borrower does not need any money, and foreclose when the borrower is in distress. Development bankers should be different; they should lend a helping hand in moments of distress, and make up for the risk they take by extracting larger returns when the borrower recovers.

For that reason, development banks should not operate on a fixed rate of interest. They should evolve a mechanism which depends on the health of the borrower. One possibility is to take a share of the profits. However, that is highly risky. Profit-related investment is best left to venture capitalists. In risk taking, development banks fall midway between safety-conscious traditional banks and the daredevil venture capitalists. In seeking returns, they need to follow a via media — neither be inflexible with a fixed rate of interest, nor be volatile and bet on equity.

For development banks, a charge on the running costs of the firm could be that via media, specifically two of them, (a) rents which include the cost of all outsourcing of materials and services, and (b) wages. Then, a charge on the rent and wage costs of the borrowing firm, a charge levied only when the firm has a surplus to pay, could be the via media that development banks could adopt.

These two costs are linked to inflation and to national economic growth too. Hence, however low the charge on these two items, it will, in due course, overtake whatever fixed rate of interest one may consider as an alternative. In initial years, the returns from such a charge will be low; even nil. In course of time, whatever sacrifice is made in the teething (or difficult) years will always be made good — unless the firm is incurable.

An unsympathetic fixed interest burden often makes otherwise curable firms mortally ill. A flexible charge will give a breather to recover to many firms that are liable to become incurably sick in a fixed interest regime. Flexible charges reduce risks for lending banks too: Because of inflation and growth, a charge on rents and wages will sooner or later overtake any fixed rate of interest. With patience, development banks can recover their sacrifices with little risk.

In other words, development banks should think differently, and should have a long time horizon. They should acquire the expertise to assess the optimum waiting period and fix the rate of charge on wage costs and rents paid accordingly. Incidentally, this kind of charge is not only transparent; it will also make firms cost-conscious. That is an added benefit, additional safety.

If development banks charge variable returns, they will need a complementary deposit regime. Pensioners like to have constant real returns that are protected against erosion by inflation. Hence, they need returns that rise with time. Thus, development banks would do well to devise a Pension Fund with inflation-linked returns. Then, they will have a matched programme for assets and liabilities.

Sir Arthur Lewis won the Nobel for explaining how poor countries can develop quickly by exploiting the surplus labour they have. On the same analogy, the rural areas can develop rapidly by exploiting the cheap land they have in plenty. The scheme PURA (Providing Urban amenities in Rural Areas) banks on that idea. PURA starts with the construction of a ring road linking a loop of villages. The moment the road is built, the value of land alongside increases. PURA goes further. It runs frequent bus services on the ring road, at least once 10-15 minutes. With bus services in place, the ring road connects to large numbers of customers. That connectivity will attract many new businesses, increasing land values further. Every new business can become a magnet for yet another setting into motion a virtuous cycle, and to rapid growth and development of newer and newer businesses.

Then, a project like PURA is best funded by levying a charge on rising rents rather than depending on a relatively high fixed rate interest. With fixed rate of interest, compounded every three months, a project like PURA may not take off at all. A more patient, a more farseeing development bank can fund a competent real estate developer and share - not his profits - but the rents he gets.

Traditional banking is lending to the real estate developer at a fixed rate of interest. Venture funding is taking a share in his profits, but development banking is the policy of placing a charge on the rents collected. That is not normal and requires a change in the mindset, a new vision, which could give development banks a new life.

(The author is former Director, IIT Madras. Response may be sent to: indresan@vsnl.com)

This is 121st in the Vision 2020 series. The previous article was published on April 5.

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