Development Finance Institutions

A typical structure of financial system in any economy consists of financial institutions, financial markets, financial instruments and financial services. The functional, geographic and sectoral scope of activity or the type of ownership are some of the criteria which are often used to classify the large number and variety of financial institutions which exist in the economy. In its broadest sense the term ‘financial institution’ would include banking institutions and non-banking financial institutions.

 The banking institutions may have quite a few things in common with the non-banking ones. However, the distinction between the two has been highlighted by Sayers, by characterising the former as ‘creators’ of credit, and the latter as mere ‘purveyors’ of credit2. This distinction arises from the fact that banks, which are part of payment system, can create deposits and credit but the non-banking institutions, which are not part of payment system, can lend only out of the resources put at their disposal by the savers.

An efficient and robust financial system acts as a powerful engine of economic development by mobilising resources and allocating the same to their productive uses. It reduces the transaction cost of the economy through provision of an efficient payment mechanism, helps in pooling of risks and making available long-term capital through maturity transformation. By making funds available for entrepreneurial activity and through its impact on economic efficiency and growth, a well-functioning financial sector also helps alleviate poverty both directly and indirectly.

In a developing country, however, financial sectors are usually incomplete in as much as they lack a full range of markets and institutions that meet all the financing needs of the economy. For example, there is generally a lack of availability of long-term finance for infrastructure and industry, finance for agriculture and small and medium enterprises (SME) development and financial products for certain sections of the people. The role of development finance is to identify the gaps in institutions and markets in a country’s financial sector and act as a ‘gap-filler’. The principal motivation for developmental finance is, therefore, to make up for the failure of financial markets and institutions to provide certain kinds of finance to certain kinds of economic agents. The failure may arise because the expected return to the provider of finance is lower than the market-related return (not with standing the higher social return) or the credit risk involved cannot be covered by high risk premium as economic activity to be financed becomes unviable at such risk-based price. Development finance is, thus, targeted at economic activities or agents, which are rationed out of market.

The vehicle for extending development finance is called development financial institution (DFI) or development bank. A DFI is defined as "an institution promoted or assisted by Government mainly to provide development finance to one or more sectors or sub-sectors of the economy. The institution distinguishes itself by a judicious balance as between commercial norms of operation, as adopted by any private financial institution, and developmental obligations; it emphasizes the "project approach" - meaning the viability of the project to be financed – against the "collateral approach"; apart from provision of long-term loans, equity capital, guarantees and underwriting functions, a development bank normally is also expected to upgrade the managerial and the other operational pre-requisites of the assisted projects. Its insurance against default is the integrity, competence and resourcefulness of the management, the commercial and technical viability of the project and above all the speed of implementation and efficiency of operations of the assisted projects. Its relationship with its clients is of a continuing nature and of being a "partner" in the project than that of a mere "financier" " (Scharf and Shetty, 1972).

Thus, the basic emphasis of a DFI is on long-term finance and on assistance for activities or sectors of the economy where the risks may be higher than that the ordinary financial system is willing to bear. DFIs may also play a large role in stimulating equity and debt markets by

(i) selling their own stocks and bonds;

(ii) helping the assisted enterprises float or place their securities and

(iii) selling from their own portfolio of investments.

The development finance institutions or development finance companies are organizations owned by the government or charitable institution to provide funds for low-capital projects or where their borrowers are unable to get it from commercial lenders.

Types of Finance provided are – Medium (1 – 5 years) and Long term ( >5 years).

Development Financial Institutions are specialized institutions set up primarily to provide development/ Project finance especially in developing countries. These development banks are usually majority-owned by national governments. The source of capital of these banks is national or international development funds. This ensures their creditworthiness and their ability to provide project finance in a very competitive rate.

The government support to DFI was also declining due to fiscal reasons or building the market more competitive and effi­cient. Fiscal imperatives and market dynamics have forced the government to under­take reappraisal of its policies and strategy with regard to the role of DFIs in Indian system. However, it is important to note that our country has not achieved its develop­ment goals even then due to unavoidable circumstances like economic reforms we have started the restructuring process of DFIs after 1991.

Development Financial Institutions (DFIs) were established with the Government sup­port for underwriting their losses as also the commitment for making available low cost resources for lending at a lower rate of interest than that demanded by the market for risky projects. In the initial years of development it worked well. Process of infrastruc­ture building and industrialization got accelerated. The financial system was improved considerably as per the needs of projects.

Appraisal system of long term projects had also been strengthened due to improvement in availability of information and skills. Thus, the DFIs improved their appetite for risk associated with such projects. “The intermedi­aries like banks and bond markets became sophisticated in risk management techniques and wanted a piece of the pie in the long term project financing. These intermediaries also had certain distinct advantages over the traditional DFIs such as low cost of funds and benefit of diversification of loan portfolios”.

India’s experiment with development banking began with the establishment of the Industrial Finance Corporation of India (IFCI) in July 1948, and continues to this day, even if in considerably diminished form. There have been three phases in the evolution of development banking. The first began with Independence and extends to 1964 when the Industrial Development Bank of India was established, which was the phase of creation and consolidation of a large infrastructure. As institutions were established the scope of development banking in India increased, but even in 1970-71 disbursements by all financial institutions (including investment institutions such as the Life Insurance Corporation [LIC], Unit Trust of India [UTI] and General Insurance Corporation [GIC]) amounted to just 2.2 per cent of gross capital formation. The second period stretched from 1964 to the middle of the 1990s when the role of the DFIs gained in importance, with the assistance disbursed by them amounting to 10.3 per cent of Gross Capital Formation in 1990-91 and 15.2 per cent in 1993-94. Thirdly, after 1993- 94, the importance of development banking declined with the decline being particularly sharp after 2000-01, as liberalisation resulted in the exit of some firms from development banking and in a decline in the resources mobilised by other firms.

By 2011-12, assistance disbursed by the DFIs amounted to just 3.2 per cent of Gross Capital Formation.1 In the first two of these periods, the nature of the DFIs, their mandate and the way they obtained resources marked them out as entities that were part of a dirigiste regime. During those years the Indian government followed a highly interventionist development strategy, with controls on trade and foreign investment, regulation of investment choices and decisions, strong exchange rate management and a large public sector. It is true that even during this period the World Bank, the Asian Development Bank, the International Financial Corporation and bilateral aid institutions were important providers of finance to India. But they did not approve of India’s interventionist strategy and for long the World Bank was even wary of lending to the pubic sector. Thus, India’s development finance institutions were also important from the point of view of the ability of the state to pursue its own independent strategy, however inadequate that may subsequently have proved.

However, the institutional changes needed to successfully implement the strategy these interventions sought to advance were never implemented. This was especially true of land reform, the role of which was seen as crucial because productivity increase in agriculture was hampered by land monopoly and predatory absentee landlordism. Moreover, the desire to “catch up” with the developed countries through an emphasis on factory-based industrialisation meant that there was considerable neglect of agriculture, which was seen as a “bargain sector” that would deliver additional output without much investment, largely based on institutional changes such as land reform and subsequent cooperativisation (which was never implemented) (Chandrasekhar 2011). Further, there was little concern for sustainability and the environment, with large projects (such as big dams, chemical plants, power projects and large scale mining) being pushed through despite their adverse environmental effects, and with little effort to mitigate those effects.

Difference from Commercial Banks

DFIs differentiates itself from commercial banks as it strikes a balance between commercial operational norms as followed by commercial banks on one hand, and developmental responsibilities on the other. They provide long-term loans, guarantees and underwriting functions. DFIs provide long term finance to fund the activities to those sectors where the risk is higher for the commercial banks to finance. So, DFIs are not just plain lenders like commercial banks but they act as companions in the development of significant sectors of the economy. After independence, as the role of commercial banks were limited to providing working capital financing for short periods, the DFIs were set up to finance the development on long term basis for the significant sectors of the economy like infrastructure sector.

Objectives of Development Finance Institutions

• The prime objective of DFI is the economic development of the country
• These banks provide financial as well as the technical support to various sectors
• DFIs do not accept deposits from people
• They raise funds by borrowing funds from governments and by selling their bonds to the general public
• It also provides a guarantee to banks on behalf of companies and subscriptions to shares, debentures, etc.
• Underwriting enables firms to raise funds from the public. Underwriting a financial institution guarantees to purchase a certain percentage of shares of a company that is issuing IPO if it is not subscribed by the Public.
• They also provide technical assistance like Project Report, Viability study, and consultancy services.

Classification

The Development Finance Institutions can be classified into four categories:

Functionally, all-India institutions can be classified as:

(i) Term-lending institutions (IFCI Ltd., IDBI, IDFC Ltd., IIBI Ltd.) extending long- term finance to different industrial sectors,

(ii) Refinancing institutions (NABARD, SIDBI, NHB) extending refinance to banking as well as non-banking intermediaries for finance to agriculture, SSIs and housing sectors,

(iii) Sector-specific/specialised institutions (EXIM Bank, TFCI Ltd., REC Ltd., HUDCO Ltd., IREDA Ltd., PFC Ltd., IRFC Ltd.), and

(iv) Investment institutions (LIC, UTI, GIC, IFCI Venture Capital Funds Ltd., ICICI Ven­ture Funds Management Co. Ltd.). State/regional level institutions are a distinct group and comprise various SFCs, SIDCs and NEDFi Ltd.

Some Important DFIs (Sector Specific)

Industry

IFCI – 1st DFI in India. Industrial Corporation of India was established in 1948.

ICICI – Industrial Credit and Investment Corporation of India Limited established in 1955 by an initiative of the World Bank.

• It established its subsidiary company ICICI Bank limited in 1994.
• In 2002, ICICI limited was merged into ICICI Bank Limited making it the first universal bank of the country.

Universal Bank – Any Financial institution performing the function of Commercial Bank + DFI

• It was established in the private sector and is still the Only DFI in the private sector.

IDBI – Industrial Development Bank of India was set up in 1964 under RBI and was granted autonomy in 1976

• It is responsible for ensuring adequate flow of credit to various sectors
• It was converted into a Universal Bank in 2003

IRCI – Industrial Reconstruction Corporation of India was set up in 1971.

• It was set up to revive weak units and provide financial & technical assistance.

SIDBI – Small Industries development bank of India was established in 1989.

• Was established as a subsidiary of IDBI
• It was granted autonomy in 1998

Foreign Trade

EXIM Bank – Export-Import Bank was established in January 1982 and is the apex institution in the area of foreign trade investment.

• Provides technical assistance and loan to exporters

Agriculture Sector

NABARD – National Bank for agriculture and rural development was established in July 1982

• It was established on the recommendation of the Shivraman Committee
• It is the apex institution in the area of agriculture and rural sectors
• It functions as a refinancing institution

Housing

NHB- National Housing Bank was established in 1988.

• It is the apex institution in Housing Finance

Aspirants can also read about micro-finance at the linked article.

Role of DFIs in Indian Economy

In India, the role of DFIs is to support long term infrastructures of industry and agriculture. The DFIs were set up under the full control of both Central and State Governments. These institutions were used by the government for spurring economic growth and aid social development. The DFIs provide finance to all those entities which are not adequately served by the banks and capital markets like households, SMEs, and private corporations.

(i) It is supposed to identify the gaps in efficacy of institutions and markets and act as a ‘gap-filler’.

(ii) It makes up for the failure of financial markets and institutions to provide certain kinds of finance to economic agents who are really interested to improve the work­ing of economy.

(iii) It targets at economic activities or agents, which are rationed out of market. It motivates the agent to take risky business with venture finance.

(iv) It helps the funds seekers by providing concessional funds at lower rate of return. Social return of DFIs is quite high. Keeping these facts in mind central banking system also supports development financial institutions.

(v) It is specialized in nature and involved long term finance. It is exclusively meant for infrastructure and industry, finance for agriculture and small and medium enterprises (SME) development and financial products for certain sections of the people who needs funds for development perspectives.

Nature of Development

Diamond William (1957) defines development institutions as “an institution to promote and finance enterprises in the private sector”. According to Boskey Shirley, “The deve­lopment banks are, institutions, public/private, which have one of their principal func­tions, as the making of medium and long term investment in the industrial projects”. According to Nyhart and Janssens development banks are ‘ those institutions, which pro­vide general medium term and long-term financial assistance to a developing economy”.

The World Development Report (1989) defines, “financial intermediaries are those, which emphasis the provision of capital (loans and equity) for development. It may specialize in particular sector, for example, industry, agriculture or housing”.

Hook (1976), also suggests, that the development banks have two functions to perform i.e. banking and development.” As a banker, the development banks are expected to finance those projects, which are “Bankable”. A project is bankable if it is in the nature of self-financing.

Elaborating self-financing projects, Kane J.A. says that “a project is self- financing, if it is able to generate enough income within a specified period of time to

(i) cover the cost of operations, (once the plants begin the operations),

(ii) repay the principle and interest charges thereon and

(iii) lease a residual profits enough to remain in the operations.”

It is specialized mode of extending development finance and it is generally called as development financial institution (DFI) or development bank. A DFI is defined as “an institution promoted or assisted by the government to provide development finance to sectors of the economy. The institution distinguishes itself by a judicious balance as between commercial norms of operation, as adopted by any private financial institution, and developmental obligations; it emphasizes the “project approach”.

A development bank is expected to upgrade the managerial and the other operational pre-requisites of the assisted projects. Its insurance against default is the integrity, competence and resource­fulness of the management, the commercial and technical viability of the project and above all the speed of implementation and efficiency of operations of the assisted projects. Its relationship with its clients is of a continuing nature and of being a “partner” in the project than that of a mere “financier”.

These definitions outlined the pervasive nature of the development banks. There are different types of promoters for DFIs. Some DFIs are found to be the government spon­sored, others are privately owned, and still others are in both hands. These DFIs are engaged in providing different types of services. Promotional and entrepreneurial ser­vices are the main theme of these DFIs. These services carry a commitment towards faster growth and fulfilment of the aspirations of the economy.

Thus, the DFIs are necessary for long-term finance and other assistance for activities or sectors of the economy. In emerging sectors risks may be higher than that the ordinary financial system and they are unable to bear the risks involved. They have also been playing effective role in stimulating equity and debt markets by-

(i) selling their own stocks and bonds;

(ii) helping the assisted enterprises float or place their securities and

(iii) selling from their own portfolio of investments.

In this way, “a development bank is intended to provide a necessary capital, enterprise, managerial and technical know-how as these are inadequate in developing economy like India. They also assist in building up the financial and socio-economic infrastructure, favourable to quick economic development. The emphasis on its various activities has shifted from one country to another according to its peculiar needs and circumstances. In some countries the stress has been on finance; in some others, on promotion; yet in others on technical skill and advice; and again elsewhere on economic planning itself.”

Evolution of DFIs in India

In India, the first DFI was operationalised in 1948 with the setting up of the Industrial Finance Corporation (IFCI). After the passage of state Financial corporations (SFcs) Act, 1951, state level small and medium-sized financial corporations were established. It was succeeded by the establishment of industrial Finance Corporation of India (IFCI). In 1955, the first DFI in private sector, the Industrial Credit and Investment Corporation of India (ICICI), was set up with the backing of the World Bank. In 1958, Refinance Corporation for Industry, which was taken over by the Industrial Development Bank of India (IDBI) was established. In 1963, Agriculture Refinance Corporation was established.

The major development in the institution building was the establishment of IDBI as an apex term-lending institution, and that of the Unit Trust of India (UTI), as subsidiaries of the Reserve Bank of India (RBI) in 1964. Similarly, in 1960s, State Industrial Development Corporations (SIDCs) were developed in the states.

The following are some of the major institutions set up after 1974:

• 1981: NABARD
• 1982: EXIM Bank
• 1986: Shipping Credit and Investment Company of India (SCICI)
• 1987: Indian Renewable Energy Development Agency (IREDA)
• 1988: ICICI Venture Funds Management Ltd.
• 1988: National Housing Bank (NHB)
• 1989: Tourism Finance Corporation of India (TFCI)
• 1990: Small Industries Development Bank of India (SIDBI)

Industrial Finance Corporation of India (IFCI), Industrial Development Bank of India (IDBI), National Bank for Agriculture and Rural Development (NABARD), National Housing Board (NHB) and Small Industry Development Bank of India (SIDBI) were all launched with majority ownership of the Reserve Bank of India (RBI).

As mentioned earlier, DFIs are created in developing countries to resolve market failures, especially in regard to financing of long-term investments. The DFIs played a very significant role in rapid industrialisation of the Continental Europe. Many of the DFIs were sponsored by national governments and international agencies. The first government sponsored DFI was created in Netherlands in 1822. In France, significant developments in long-term financing took place after establishment of DFIs such as Credit Foncier and Credit Mobiliser, over the period 1848-1852. In Asia, establishment of Japan Development Bank and other term-lending institution fostered rapid industrialisation of Japan. The success of these institutions, provided strong impetus for creation of DFIs in India after independence, in the context of the felt need for raising the investment rate. RBI was entrusted with the task of developing an appropriate financial architecture through institution building so as to mobilise and direct resources to preferred sectors as per the plan priorities. While the reach of the banking system was expanded to mobilise resources and extend working capital finance on an ever-increasing scale, to different sectors of the economy, the DFIs were established mainly to cater to the demand for long-term finance by the industrial sector. The first DFI established in India in 1948 was Industrial Finance Corporation of India (IFCI) followed by setting up of State Financial Corporations (SFCs) at the State level after passing of the SFCs Act, 1951.

 Financial Institutions set up between 1948 and 1974

Besides IFCI and SFCs, in the early phase of planned economic development in India, a number of other financial institutions were set up, which included the following. ICICI Ltd.4 was set up in 1955, LIC in 1956, Refinance Corporation for Industries Ltd. in 1958 (later taken over by IDBI), Agriculture Refinance Corporation (precursor of ARDC and NABARD) in 1963, UTI and IDBI in 1964, Rural Electrification Corporation Ltd. and HUDCO Ltd. in 1969-70, Industrial Reconstruction Corporation of India Ltd. (precursor of IIBI Ltd.) in 1971 and GIC in 1972. It may be noted here that although the powers to regulate financial institutions had been made available to RBI in 1964 under the newly inserted Chapter IIIB of RBI Act, the definition of term ‘financial institution’ was made precise and comprehensive by amendment to the RBI Act Section 45-I (c) in 19745.

 DFIs set up after 1974 and Notification of certain institutions as Public Financial Institutions

Another important change that took place in 1974 was the insertion of Section 4A to the Companies Act, 1956 whereunder certain existing institutions were categorised as ‘Public Financial Institutions’ (PFI) and the powers of Central Government to notify any other institution as PFI were laid down. In exercise of these powers GOI has been notifying from time to time certain institutions as PFIs. As on date, under the Section 4A, six specified institutions are regarded as PFI and it has been provided that the Securitisation Company or Reconstruction Company which has obtained a certificate of registration under sub-section (4) of Section 3 the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 shall also be regarded as a PFI. Besides these institutions, GOI has been notifying, from time to time, certain other FIs as PFIs and as on date additional 46 institutions have been so notified. Thus, in all 52 institutions have been categorised as PFIs.

The FIs set up after 1974 have been as follows. NABARD was set up in 1981, EXIM Bank (functions carved out of IDBI) in 1982, SCICI Ltd. in 1986 (set up by ICICI Ltd. in 1986 and later merged into ICICI Ltd. in 1997), PFC Ltd. and IRFC Ltd. in 1986, IREDA Ltd. in 1987, RCTC Ltd. and TDICI Ltd. (later known as IFCI Venture Capital Funds Ltd. and ICICI Venture Funds Management Ltd.) in 1988, NHB in 1988, TFCI Ltd. (set up by IFCI) in 1989, SIDBI (functions carved out of IDBI) in 1989, NEDFi Ltd. in 1995 and IDFC Ltd. in 1997.

As may be observed from the foregoing, over the years, a wide variety of DFIs have come into existence and they perform the developmental role in their respective sectors. Apart from the fact that they cater to the financial needs of different sectors, there are some significant differences among them. While most of them extend direct finance, some extend indirect finance and are mainly refinancing institutions viz., SIDBI, NABARD and NHB which also have a regulatory / supervisory role.

DFIs can be broadly categorised as all-India or state / regional level institutions depending on their geographical coverage of operation. Functionally, all-India institutions can be classified as (i) term-lending institutions (IFCI Ltd., IDBI, IDFC Ltd., IIBI Ltd.) extending long-term finance to different industrial sectors, (ii) refinancing institutions (NABARD, SIDBI, NHB) extending refinance to banking as well as non-banking intermediaries for finance to agriculture, SSIs and housing sectors, (iii) sector-specific / specialised institutions (EXIM Bank, TFCI Ltd., REC Ltd., HUDCO Ltd., IREDA Ltd., PFC Ltd., IRFC Ltd.), and (iv) investment institutions (LIC, UTI, GIC, IFCI Venture Capital Funds Ltd., ICICI Venture Funds Management Co Ltd.). State / regional level institutions are a distinct group and comprise various SFCs, SIDCs and NEDFi Ltd. 

Declining role of DFIs post-liberalization

After 2000-2001, the prominence of development banking has started to decline as many firms from development banking had quit post liberalization. During 2002-2004, ICICI and IDBI were turned into commercial banks. From then, the share of the development banks fell down to just 30% from two-thirds. The government found that the DFIs failed miserably to provide credits to small scale sector and rural farm sectors for long term. Also, they do not have low cost deposits in the form of current and savings accounts similar to that of commercial banks. Until reforms in 1991, the DFIs had access to state funding. But after 1991 reforms, reduced public spending in DFIs resulted in their decline. So, the DFIs had to rely on a variety of methods to fill the gap created by the reduced state funding. There were growing reliance on bank credit, private equity in corporate financing and external commercial borrowing (ECBs).

Universal banking replacing DFIs in India

At present the line between the role of DFIs and commercial banks have blurred due to overlapping of their functions. Nowadays, the commercial banks are actively involved in developmental financing similar to that of the DFIs, especially after the merger of ICICI and IDBI within the banking system. So, nowadays the commercial banks are often called as the universal banks as it provides all types of financial services.

The DFIs role of industrialization and the developmental finance till the onset of liberalization cannot be denied. They were crucial to realize the larger developmental goals as prescribed by the Five Year Plans. Though, as of now, the commercial banks have largely taken the place of DFIs in developmental financing, they are unlikely to emphasize environmental and social concerns while making investment decisions and lending, especially if they result in reduction in profitability. In India, it has been observed that the greater private participation in developmental banking has often resulted in accumulation of private profit rather than social benefit. Hence, it would be wise to revive the concept of DFI if the government wishes to keep societal, cultural, regional, rural and environmental concerns intact while financing long term developmental projects.

Rationale of DFIs in India

The DFIs were set up in India on the following rationale:

(i) Improving Rates of Savings and Investment:

In initial years rate of capital forma­tion was low. At the time of independence saving rate was around at 5 per cent of national income. India had a fairly diversified industrial base for a developing country, with a number of well-established industrial houses at the time of inde­pendence. So necessary guarantee was expected from the DFIs otherwise entre­preneurs and promoters would have not been able to generate resources from the market.

(ii) Infancy Stage of Capital Market:

The capital market was at infancy stage and industries had to depend on their own profits and banks for financing for further development programmes. That is why these funds institutions, investment insti­tutions, other trusts, etc. has been declared as DFIs in terms of public financial institutions (PFI) under Section IV-A of Companies Act, 1956.

(iii) Risk Averse Commercial Bank:

Commercial banks were not interested in venture financing as they are quite risky one. DFIs are specialised financial institutions and well equipped in risky venture.

(iv) Arrangement of Loan in Foreign Currency:

Earlier, DFIs had access to lines of credit in foreign currencies from various multilateral and bilateral agencies at low rates of interest mainly for project financing. The Central Government had as­sumed all foreign currency risks due to fluctuation in the exchange rates.

(v) Specialized Credit Support System:

DFIs could sanction and disburse credit at fixed/assured rates spread over their borrowing rates till the early 1990. More­over, under the existing industrial licensing policy system obtaining a license itself was taken as license to get credit from DFIs, without the investor going through the elaborate procedures normally associated with projected appraisal for credit sanction based on commercial judgment and viability.

(vi) Arrangement of Priority Sector Financing:

DFIs did not have competition in deploying their funds to public companies. However, some commercial banks had started providing term capital as priorities for investments in various sectors in the economy were given, along with targets set in successive plans.

(vii) Project Evaluation and Funding:

Some DFIs had also conducted economic poten­tial surveys of regions or states and provided considerable support to a number of development projects. When project costs were high and could not be financed by one DFI, they formed loan consortia with commercial banks whereby DFIs could provide large sized loans thereby reducing the incidence of risks.

(viii) Coordinating Financing Agencies:

The DFIs were expected to work as conduits between the government/other financing agencies and the ultimate borrowers for an assured margin. They also acquired skills and expertise to study the viabi­lity and technical efficiency of projects which was called as the directly produc­tive activities.

Development Financial Institutions (DFIs) in India  – 

Challenges before DFIs

The DFIs are facing the following challenges:

(i) Problems in Mobilisation of Resources: The DFIs have to mobilize funds from the market but they suffered from structural inflexibility as they did not have good network of branches all over the country. There are restrictions on the amount of funds that could float in the market. Now interest rates are quite competitive and these DFIs are not getting funds at competitive rates.

(ii) Problem of Competitive Interest Rate:

The DFIs have to also cut down their lend­ing rates to levels set by commercial banks and also provide access to their funds as liberally as the banks without, a matching reduction in their own borrowing costs. The DFIs are not habitual of flexible interest rates and they are losing their business from the corporate sector.

(iii) Removal of Concessional Rate Regime:

DFIs’ access to borrowings from the Cen­tral Government at a highly concessional rate of interest was withdrawn in a phased manner, since the fiscal deficit which led to the external current account deficit. Since 1991 banking sector reforms have changed the business environment of DFIs.

(iv) Flexible Mode of Fund Generation:

DFIs access to short term sources of funds is quite limited. It is notable that Term deposits, certificates of deposits, term money borrowing inter-corporate deposits and commercial papers all put together are equivalent to their Net Owned Fund. Thus, it is inflexible as well as expensive for DFIs to generate fund in present scenario.

The DFIs have to mobilize funds from the market but they suffered from structural inflexibility as they did not have good network of branches all over the country. There are restrictions on the amount of funds that could float in the market. Now interest rates are quite competitive and these DFIs are not getting funds at competitive rates.

(v) Competitive Environment:

As part of banking reforms, bank was given consider­able freedom to extend term loans, project finance etc. Earlier, it was exclusive domain of DFIs. Thus, DFIs are facing stiff competition from bank in disburse­ment of term capital.

(vi) Adverse Liquidity Position:

The merger in the 1990s of many domestic firms for improving competitiveness and introducing new technologies had also an impact on DFIs adversely, since some of the older firms that could not compete effectively could not stay in the market. Therefore they could not repay their dues on schedule, placing enormous pressure on the DFIs liquidity position.

(vii) Stringent Prudential Norm:

The severe strain on the financial position of the DFIs increased when the institutions were brought under the purview of regulation and supervision of the RBI. The regulation and supervision required the DFIs to comply with internationally recognized stringent prudential norms relating to asset classification, capital adequacy, provisioning and income recognition and standards relating to risk management of their portfolios and market exposures.

(viii) Discriminatory Government Support System:

Due to change in Government policy- there was adverse impact on the performance of DFIs. The NABARD, SIDBI and NHB continued to receive governmental support even after the shift in the policy regime. Remaining DFIs are not under the list of discriminatory government sup­port.

Inspite of above problems, DFIs in general undertook a number of measures to reposi­tion and reorient their operations as warranted by the competitive environment. Accordingly, a number of innovative non-traditional products and services were offered, viz., investment banking, stock broking, custodial services, technical advice, etc. with a view to reduce the risks by exploiting the economies of scale. They also established man­agement teams to handle finances, market products, and reduce delays in decision-mak­ing, even though such initiatives entailed additional costs.

Nature and functions of major developmental financial institutions are given below:

1. Industrial Finance Corporation of India (IFCI Ltd.):

It is India’s first development finance institution, was set up in 1948 on July 1 under the Industrial Finance Corporation Act, 1948 as a statutory corporation to pioneer industrial credit to medium and large scale industries. The constitution of IFCI was changed in May 1993 from a statutory corporation to a company under the Companies Act, 1956 providing the institutions with greater flexibility to respond to the needs of the rapidly changing financial system as also greater access to the capital markets.

The operations of IFCI’s comprise project finance, financial services and corporate advisory services. It is providing long-term financial support to all the segments of the Indian industry, export promotion, import substitution, entrepreneurship development, pollution control, energy conservation and generation of both direct and indirect employment. It provides custo­dial and investor services, rating and venture capital services through its subsidiaries/ associate companies.

2. Industrial Credit and Investment Corporation (ICICI):

It was established in 1955. It facilitated industrial development in line with economic objectives of the time. It evolved several new products to meet the changing needs of the corporate sector. It provided a range of wholesale banking products and services, including project finance, corporate finance, hybrid financial structures, syndication ser­vices, treasury-based financial solutions, cash flow based financial products, lease financing, equity financing, risk management tools as well as advisory services.

It also played a facilitating role in consolidation in various sectors of the Indian industry by funding mergers and acquisitions. In the context of the emerging competitive scenario in the financial sector ICICI Ltd. had been integrated into a single full-service banking company as ICICI Bank in May 2002.

 3. Industrial Development Bank of India (IDBI):

It was established on 1st July, 1964 under an act of Parliament as a wholly owned subsi­diary of the Reserve Bank of India. In February 1976, its ownership was transferred to the Government of India and it was made as the principal financial institutions for co­ordinating the activities of institutions engaged in financing, promoting and developing industries in the country. Current shareholding of the Government of India is 58.47%.

Due to change in operating environment, Government of India decided to transform IDBI into a commercial bank. The IDBI (Transfer of Undertaking and Repeal) Act, 2003 was consequently enacted by Parliament in December 2003. The Act provides for repeal of IDBI Act, corporatisation of IDBI and transformation into a commercial bank.

The provisions of the Act have come into force from 2nd July, 2004 in terms of a Government Notification to this effect. The IDBI has already commenced banking business in accor­dance with the provisions of the new Act in addition to the business being transacted under IDBI Act, 1964.

4. Industrial Investment Bank of India Ltd. (IIBI):

It was set up in 1971 for rehabilitation of sick industrial companies. It was again reconsti­tuted as industrial reconstruction bank of India in 1985 under the IRBI Act, 1984. With a view to converting the institutions, IRBI was incorporated under the Companies Act, 1956, as Industrial Investment Bank of India Ltd. (IIBI) in March 1997.

It offers a wide range of products and services, including term loan assistance for project finance, short duration non-project backed financing, working capital/other short term loans to com­panies, equity subscription, asset credit, equipment finance and investment in capital market and money market instrument.

 5. Infrastructure Development Finance Company Ltd. (IDFC):

It was incorporated in 1997. It was conceived as specialized institutions to facilitate the flow of private finance to commercially viable infrastructure projects through innova­tive products and processes. Telecom, power, roads, ports, railways, urban structure together with food and agriculture-related infrastructure.

Besides, it assists the develop­ment of urban water and sanitation sectors. It has also taken new initiatives in the areas of tourism, health care and education. It provides assistance by way of debt and equity support, mezzanine structures and advisory services. It encourages banks to participate in infrastructure projects through take-out financing for a specific term and at a pre­ferred risk profile.

Plan-Wise Assistance Sanctioned and Disbursed to DFIs in India:

The DFIs in India are playing very important role in providing financial assistance to different sectors of the economy. The volume of sanctions aggregated to Rs.919655.9 crores and that of disbursements to Rs.651109.2 crores during 1948-2006. The disburse­ment to sanction ratio (DSR) stood at 70.7 per cent for the entire period of study.

During the First five year plan, the volume assistance by DFIs recorded an increase of almost 4.6 and 2.6 fold respectively in sanctions and disbursements over the Pre-plan period (1948-51). This might be due to remarkable expansion in the operation of IFCI and the setting up of State Level Finance Corporations (SFCs) in some states of the country.

From Rs.37.47 crores, the sanctions increased to Rs.212.24 crores during the second five year plan and disbursement enhanced from Rs.15.22 crores to Rs.142.02 crores as compared to the first plan period. Moreover during the same period disburse­ment to sanction ratio (DSR) increased from 40.6 to 66.9.

It is important to note that the grant of financial assistance not only gathered momen­tum during Second plan period, but also it picked up the pace. It may be due to expan­sion in scope and coverage DFIs activities. For instance IFCI extended its assistance to hotels, introduced underwriting facility by providing guarantees for differed payments and foreign currency loans.

Similarly with foreign exchange crisis in 1957-58, foreign currency loans provided by ICICI became the main source of payment for imported equipment’s. Establishment of Refinance Corporation for Industry Ltd. (RCI) in 1958 is another significant cause for growth of assistance by DFIs.

During the Third Five Year plan, the amount of assistance by all India financial institu­tions doubled in terms of sanctions and more than three times in terms of disbursements in comparison to the second plan. Three Annual Plans (1966-69) showed the sanctions and disbursements of Rs.374.78 crores and Rs.335.93 crores respectively, which is less than the third five year plan. During 4th plan total amount disbursed was Rs.984 crore against the sanctioned amount of Rs.1453 crore.

The financial assistance extended by the AIFIs became quite encouraging during Fifth- five year plan (1974-80) as the total sanctions amounted to Rs.4737.9 crores and dis­bursements to Rs.3092.1 crores with 65.3% utilization rate.

During the sixth and seventh five year plan (1980-90) assistance provided by DFIs recorded an increase of more than three times in comparison to their respective previ­ous plans. While the aggregate of sanctions arrived at Rs.14680 crores at the end of sixth five year plan, it crossed Rs.49375 crores during the seventh five year plan.

However, the disbursement rate remained around 70% in both the plan periods. There was a plan – holiday for two years and two annual plans were introduced during 1990-92. During this period the sanctions and disbursement too remained higher than the reasonable utiliza­tion rate of 65%.

The Eighth five year plan (1992-97) showed an increasing trend, with the sanctions and disbursement reached at a considerable height of Rs.25472.8 crores and Rs.164033.9 crores respectively. It is a record, which is six times higher than the previous plan period.

During the Ninth Five year plan period (1997-02) the financial assistance of AIFIs to industrial sector was twice over the eighth five year plan. While sanctioned amount reached at Rs.447149.2 crores, the disbursement at Rs.324477.5 crores. Further from 64.4%, the disbursement sanction ratio rose to 72.6% during this plan period.

A significant acceleration in overall growth momentum across quarters was the hall mark of India’s economic resurgence during the Tenth five year plan (2002-07). Several policy directives for Development Financial Institutions (DFIs) were intended to facili­tate the process of their transition to becoming banks for their sustained viability.

These included measures aimed at financial restructuring provision of regulatory relaxation for restructured investments of creditor’s banks as well as providing Government sup­port and transfer of stressed assets of DFIs to asset reconstruction companies for man­aging their NPA levels.

Problems of Development Financial Institutions in India

Due to changed environment since 1991, the Development Financial Institutions (DFIs) were forced to reorient their lending strategies and activities towards realization of com­mercial viability and competitive efficiency.

Some of the major problems faced by DFIs in post reforms era are given below:

(i) Deregulated Market Environment:

Before the 1991 DFIs were operating in a pro­tected market with the administered rate of interest on their loans, but after 1991, they have been forced to enter into the deregulated market environment. Now Market related rate of interest is the operational base for the DFIs.

(ii) Crisis of Creditability:

The DFIs is facing the crisis of creditability in the wake of economic liberalisation, globalization and changing business environment. The NPA of these DFIs is increasing and is adversely affecting their profitability.

(iii) Growing Competition in Financial Market:

The free market economy during the 1990’s also witnessed the keen competition for DFIs from the commercial banks, NBFCs and others. At present, the commercial banks are financing both short- term and long-term finance to the corporate sector so it has created a problem for the DFIs to increase and diversify their client base.

(iv) Easy Access to Capital Market:

The liberalisation and globalization process started in the Indian economy has revived the capital market and opened the door for the corporate sector to raise their resources directly from the market. The corporate sector is not interested in the financial assistance of DFIs.

(v) Competitive Interest Rates:

The DFIs have already entered into the capital mar­ket to raise their resources. These resources are generally raised with the market rate of interest that is higher than the previously administered rate of interest, so it results in an increase of their cost of borrowings. The DFIs are also being forced to reduce their lending rates due to competition.

(vi) Accountability to Stakeholders:

The increasing access of the DFIs to the Indian capital market has created a new type of problem for them with which they were not acquainted earlier. Thus, the management of most of the DFIs in this competi­tive economy is always on their toes because of this increasing accountability from the public and more specifically from their private shareholders. Now DFIs are required to accountable to their stakeholders for transparency and reporting.

(vii) Universal Banking System:

The concept of universal banking, which has been recommended by the Khan Committee, has put the DFIs into a fix. Now the con­cept of development banking is slowly going out of fashion. They have now con­verted into an NBFC or a universal bank.

Development Financial Institutions have been assigned a crucial role in the development of the country. They have played their role in the promotion of industrial units and entrepreneurial environment. However, due to change in economic environment since 1991 continuous dilution is occurred in their working. New economic policy of the gov­ernment since 1991 has made some of the development financial institutions irrelevant in the present context of development.

Structural changes have been made in the role and objectives of some of the development financial institutions. Even today some of the financial institutions are still playing their role in proper perspective.

Financial position of DFIs regulated by RBI

It is observed that nine select all India financial institutions are being regulated and supervised by RBI at present. Out of these, three institutions viz., NABARD, NHB and SIDBI extend indirect financial assistance by way of refinance. The financial health of these three institutions is sound as their exposure is to other financial intermediaries, which in certain cases is also supported by State Government guarantees. Of the remaining six institutions, two niche players viz. EXIM Bank and IDFC Ltd. are also quite healthy. The former operates in the area of international trade financing and the latter is a new generation FI with a mandate of leading private capital into the infrastructure sector, rather than itself being a direct lender. The remaining four institutions that have been operating as providers of direct assistance, are all in poor financial health. It was observed that while the total financial assets and capital and reserves of the refinancing institutions had increased during the year ended March 31, 2003, the same of term lending institutions had decreased. In terms of some select indicators the financial position of the nine FIs as on March 31, 2003 is summarised below:

CRAR

The prescribed minimum CRAR for the FIs was 9%. The CRAR of two FIs, viz., IFCI Ltd. and IIBI Ltd. was below the prescribed minimum at (-) 0.95% and (-) 11.04% respectively. Remaining 7 FIs were maintaining CRAR above 15% - with EXIM Bank, IDFC Ltd., NHB, NABARD and SIDBI having it above 25%.

Net NPAs

Net NPAs of 5 FIs viz., EXIM, IDFC Ltd., NABARD, NHB and SIDBI were below 5%. Net NPAs of IDBI were 14.20% and the rest of the FIs viz., IFCI Ltd., IIBI Ltd. and TFCI Ltd. had the same above 20% at 29.50%, 34.72% and 20.47%, respectively.

Return on Average Assets

The Return on Average Assets was negative for both IFCI Ltd. and IIBI Ltd.; it was between 0% to 1% for IDBI and NHB; between 1% to 2% in case of SIDBI and TFCI Ltd.; between 2% to 3% in case of EXIM Bank and above 3% in case of NABARD and IDFC Ltd.

 Financial position of DFIs not regulated by RBI

In regard to the DFIs not regulated by RBI it is observed from the information available in the public domain that, as on March 31, 2003, the position is as follows. The institutions like PFC Ltd., REC Ltd., and IRFC Ltd. are making profits. Same is the case with LIC and GIC (and its erstwhile subsidiaries that have since been delinked), and UTI. However, UTI had to undergo a massive restructuring in 2001-02 as it faced severe liquidity problems. While IREDA Ltd. and NEDFi Ltd. are somewhat profitable, the two venture capital companies seem to be too small to be systemically significant. HUDCO Ltd., being a housing finance company is within the regulatory and supervisory domain of National Housing Bank, and it had declared profits. The financial position of state level institutions in general, and of SFCs in particular, is very poor.

Transformation of DFIs into banks

Pursuant to the recommendations of the Khan Working Group on Harmonizing the Role and Operations of the Development Financial Institutions and banks, a Discussion Paper was prepared outlining the issues arising out of the recommendations of the Narasimham Committee II and the Khan Working Group. Extensive discussions were held on the issues brought out in the paper and a broad policy framework was outlined in the Mid-Term Review of Monetary and Credit Policy of 1999-2000 of RBI as under:

The principle of Universal Banking was a desirable goal and some progress had already been made by permitting banks to diversify into investments and long-term financing and the DFIs to lend for working capital. However, it was emphasized that banks had certain special characteristics and any dilution of RBI’s prudential and supervisory norms for conduct of banking business would be inadvisable and any conglomerate in which banks were present should be subject to a consolidated approach to supervision and regulation. It was recognized that though the DFIs would continue to have a special role in Indian financial system, until the debt market demonstrated substantial improvement in terms of liquidity and depth, any DFI which wished to transform into a bank should have the option, provided the prudential norms applicable to the banks were fully satisfied.

To this end, a DFI would need to prepare a transition path, in order to fully comply with the regulatory requirements of a bank and, therefore, the DFIs were advised to consult RBI for such transition arrangements, which the RBI would consider on a case-to-case basis. The need for strengthening the regulatory framework of RBI in respect of DFIs, if they were to be given greater access to short-term resources for meeting their financing requirements, was recognized. It was expected that in the light of the evolution of the financial system, the Narasimham Committee’s recommendations that ultimately there should only be banks and restructured NBFCs could be operationalised.

 In tandem with the RBI policy pronouncement for DFIs, the GOI in the Mid-Year Review, 2002 made its intentions clear for decisive resolution of the problems being faced by some of the DFIs, by announcing that "financial sector reforms, involving interest rate deregulation, increased competition from banks, and lack of concessional funds have rendered the business models of development financial institutions (DFIs) unsustainable. Various expert committees have recommended measures to transform the DFIs. With the RBI’s policy in this regard crystallizing last year, ICICI transformed itself into a bank. The Government proposes to address the problems of IDBI and IFCI. It is proposed to repeal the IDBI Act and facilitate its transformation into a bank. With regard to IFCI, the government proposes to take measures keeping in mind the interest of retail investors and government guaranteed lenders."

 Efforts made by DFIs in the past to become banks

 The operational guidelines for enabling a DFI to convert to universal bank were issued in 2001, following the policy pronouncement by RBI on ‘Approach to Universal Banking’. The DFIs were advised that those who choose to convert into bank, may formulate a roadmap for the transition path and strategy for smooth conversion, over a specified time frame. It was also advised that the plan should specifically provide for full compliance with prudential norms, as applicable to banks over the proposed period and should be submitted to RBI for consideration and further discussion, if necessary.

 Out of the ten DFIs then being regulated and supervised by RBI only two DFIs i.e. ICICI Ltd. and IDBI submitted the transition path to RBI and Government, respectively, for consideration. Two DFIs expressed their intention to submit the road map, but sought more time to concretize their plan by appointment of consultants, etc. One DFI forwarded a broad road map for conversion to a restructured NBFC by 2005, also seeking support from the Government, which was considered crucial for the success of the envisaged conversion. The proposal was forwarded by RBI to the Government for their consideration.

The remaining five DFIs did not show any inclination to consider the option, as no proposal was received from them. Nothing further was heard from the DFIs who had sought time for formulating a plan for conversion. The transition plan of IDBI, which involved long winded legislative process and is finally at the stage of fructifying now, is discussed subsequently in this chapter. The road map submitted by ICICI Ltd. was successfully implemented and conversion to the bank was achieved in 2002.

 Transformation of ICICI into a bank

 The two most important factors enabling the smooth and speedy implementation of the plan of conversion by ICICI Ltd. were:

1. The ready banking platform available with it for launching itself into a universal bank, by way of backward integration with its banking subsidiary.
2. The private company character of the DFI, with resultant operational freedom and ability to leverage, the superior managerial resources and skills available with it, in steering the organization along the transition path.

 On scanning the transformation of the balance sheet of ICICI Ltd., over a five year period from 1997 to 2001, it can be concluded that the FI was working on a strategy to diversify its loans portfolio by exiting from the long term manufacturing sector project finance to short / medium term corporate lending. Clearly the FI had strategically embarked on repositioning itself, from a DFI catering largely to the project finance requirement of the industry to a provider of a variety of financial products, including the products for the retail segment and in the process, acquiring an asset profile more akin to the profile of assets, on a bank’s balance sheet. A glance at the table below would eloquently depict the transformation.

 In tune with the policy stance of RBI, that the principle of Universal Banking was a desirable goal, but at the same time the banks have certain special characteristics and as such any dilution of RBI’s prudential and supervisory norms for conduct of banking business, would be inadvisable and to this end a DFI would need to prepare a transition path in order to fully comply with the regulatory requirements of a bank, the proposal of the ICICI Ltd., for conversion into a bank was put to stringent scrutiny. The bank had to ensure that the fair valuation of the assets of the ICICI Ltd. before merger was completed to its satisfaction and provisioning requirement towards shortfall in the value of advances and investments was duly carried out in the books of ICICI Ltd., before the entities were merged.

No relaxation was given for compliance with SLR / CRR requirements, income recognition, asset classification and provisioning norms, compliance with Sections 6 and 19(1) of B. R. Act, 1949 regarding the permissible banking activity for the subsidiaries of a bank, compliance with Section 19(2) of B. R. Act, 1949 relating to limit placed on investment in any company by a bank to the extent of 30% of its own capital or 30% of investee company’s capital, compliance with Section 20 regarding prohibition on connected lending, etc. The relaxations were given to the bank in respect of shares acquired by way of assistance to project finance by ICICI Ltd., which could not be offloaded quickly and, therefore, were kept out side the limit of 5% on exposure to capital market for five years. Any incremental accretion to the equity investment as a part of project finance by the bank, however, was to be reckoned within the exposure limit on equity for the banks.

The merged entity was also exempted by Government of India for five years, from the provision of Section 12 of the B. R. Act, 1949, which prohibits issue of preference shares by a banking company as ICICI Ltd. had outstanding preference share capital of Rs.350 crore, acquired under the scheme of merger with ITC Classic Finance Ltd. These exemptions were given more by way of taking a pragmatic view of the bank’s position and giving it sufficient time for unwinding its portfolio of equity and preference shares, acquired in its previous incarnation. Similarly , the merged entity was advised to apportion a share of 50% of incremental lending to priority sector, so as to achieve the norm of 40% for priority sector lending at an early date. The interest of provident funds (PFs), which had invested in the debt instruments of ICICI Ltd. as PFI, was protected by transferring the Government guarantees on such instruments to the merged entity, even after conversion and consequent loss of PFI status.

Current efforts by DFIs for similar transformation:

At present, the IDBI is in the process of conversion to a commercial bank. It had submitted in November 2001 a proposal for conversion into a bank to Govt. of India, MOF, wherein it had sought merger with another bank through amendment to the provisions of IDBI Act, for providing an enabling legal framework for merger and to set out the scheme for merger in addition to provision for certain other exemptions and concessions, which the merger would necessitate. Subsequently, it was announced in the budget speech for 2002-2003 of the Finance Minister, that IDBI would be corporatised. Accordingly, a new approach, of repealing the IDBI Act, 1964 in its entirety by passing a Repeal Act in the Parliament and building in the Repeal Act itself, various relaxations and concessions as well as the provision to confer the status of a bank on the DFI after conversion into a company, so as to obviate the need for grant of a banking licence by RBI under the BR Act, was adopted. A bill to this effect was introduced in the Parliament in December 2002. After necessary deliberations on the bill, the IDBI (Transfer of Undertaking and Repeal) Act, 2003 was passed by the Parliament and notified by the Government of India on December 30, 2003. However, the new banking entity, sought to be created by the Repeal Act, will come into being on the appointed day which is yet to be notified by the Government. Some notable features of the Repeal Act are as under :

1. On the appointed date the undertaking of the IDBI would vest in the company to be formed and registered under Companies Act, 1956 under the name Industrial Development Bank of India Ltd.
2. The company shall be deemed to be a banking company under Section 5(c) of BR Act, 1949 and will not be required to obtain a banking licence from RBI under Section 22 of BR Act, 1949.
3. The company shall not be required to maintain for five years, from the appointed day, the prescribed percentage of liquid assets required to be maintained under Section 24 of the said Act. (SLR)
4. Central Government may in consultation with RBI direct by notification that any of the provisions of BR Act shall not apply to the company or shall apply with such exceptions, modifications and adaptations as may be specified in the notification.

IDBI, unlike ICICI Ltd., is being sought to be converted into a bank on a stand alone basis. For a new entrant to banking it will be very important to position itself correctly to stand up to the competition. There has been contraction of the balance sheet of IDBI over last 3-4 years. However, it has a preponderance of assets in the form of long term project finance. It is also carrying large amount of NPAs on its balance sheet and would require a substantial amount of provisioning for cleaning up. The provisioning requirement would further increase after migrating to stricter norm for classification of NPAs (both substandard and doubtful) as applicable to banks. The DFI has already made a request to the Government for infusion of funds. IDBI is also in touch with RBI to sort out various legal, regulatory and operational issues.

 Lessons learnt from the conversion of ICICI into a bank

The WG has reviewed the experience of only one DFI, i.e. ICICI Ltd., which has so far successfully converted into a bank. The organisational dynamics of ICICI Ltd. was different from the other DFIs especially in the public sector; therefore, the exact replication of its experience by others may not be possible. However, some tentative conclusions can be drawn from the experience of ICICI Ltd., which can serve as reference points and the underlying hypothesis can be further tested by applying these principles to future attempts at conversion by any of the DFIs. The conclusions are as under :

 Existing banking platform for conversion

A ready banking platform would greatly facilitate the conversion of a DFI into a bank. A DFI by forward or backward integration into a bank would land at a higher point on a learning curve in terms of banking experience and operational readiness. A ready infrastructure of branch network, operating procedures, technology platform, skilled manpower, etc., will make the transformation much smoother and efficient than conversion of a DFI on a stand alone basis and attempting to build the entire banking infrastructure from the scratch. The process of transformation on a stand alone basis would require higher degree of change management skills and may have adverse effect on the operations, unless sufficient and long preparations are made for conversion. The asset liability management could cause serious concern in case of conversion on stand alone basis. The assets liability mismatch could arise since the deposit base of the converted entity would build up only gradually. Unless the bank has ready and liquid assets to discharge its short and medium term liabilities or alternatively it is permitted to raise resources through bond issue, serious liquidity problems could arise. The teething problem would be manageable in case of a DFI merging with a bank of a size commensurate with the balance sheet of DFI.

 De-risking and diversification of loan portfolio

Long term project finance is a risky proposition for any financial intermediary and more so for a DFI whose loan portfolio is almost exclusively comprised of project financing. Therefore, in preparation for conversion to a bank the DFI should consciously scale down the proportion of project financing by resorting to diversified products, e.g., structured finance and innovative financial techniques. It would be much easier for DFI to transform to a bank if its asset profile, is poised somewhere between a DFI and bank's assets profile rather than exclusively a DFI's asset profile. A bank's liquidity profile is very crucial from a systemic point of view and therefore the regulator would also be comfortable with a bank, which would not pose any risks to the system because of its highly illiquid asset portfolio.

 Flexibility of organisational structure

A flexible and agile organisational structure is a pre-requisite for meeting the challenges in a competitive environment. A company structure possesses the attributes of operational flexibility and is best suited for the role of a financial intermediary. Therefore, any DFI seeking transformation to a bank should necessarily migrate to the structure of a company, preferably with a large and diversified share holding .

 Correct positioning and business strategy

The choice of the target clientele, appropriate business and product mix to be offered, in face of the acute competition in the banking sector and mechanism for delivery of banking services and compliance with statutory and regulatory requirements, over a self determined time horizon despite relaxations given for a specified time period, should be formulated well before embarking on conversion to bank and there should be ongoing monitoring of the business and strategic plan till the entity is fully integrated into the banking system.

 Availability of management skills

In an organisation transforming to a new role, there would be a significant need for skilful change management, by retraining and equipping the managerial personnel with new set of skills and facilitating their adaptation to a new working style and environment. An organisation undergoing a transformation must give top priority to this aspect.

Brand Equity

The brand image of an organisation would determine its success or failure in any role. A good image has to be assiduously built over a long time span and a poor image which can not be shaken off easily would be a hindrance in the transformation process. A DFI possessing brand equity can in a very short time establish itself in the market after conversion into a bank.

 Regulatory Framework for transition of DFI into bank:

 A regulatory framework would be necessary to facilitate the smooth migration of a DFI into a bank . The objective of the framework would be not to dilute the rigours of the regulation for banks, but to take a pragmatic view on certain regulations and to defer their application for a specified period of time to allow the newly created bank to smoothly adjust its asset pattern to the requirements of prudential/ statutory regulation. On grounds of practical considerations, the entities may need relaxations in the application of the regulations relating to restrictions on equity holdings acquired by way of project finance and lending to priority sector. The relaxations may, however, be given only for a specified time-period of 3 to 5 years in respect of legacy portfolio of assets as on the day of conversion and the incremental portfolio should be subject to the full rigour of regulations from the inception of the converted bank.

 No relaxation should be given, unless mandated by statute, from the prudential regulations such as minimum capital requirements, income recognition, asset classifications and provisioning norms, capital adequacy prescriptions, maintenance of CRR and SLR, building up of reserve funds besides other regulations relating to drawing of accounts and audit, permissible banking business, restriction on common directors and connected lending etc.