The case for long-term finance banks
As specialized institutions, long-term finance banks will be in a much better position to evaluate and fund long-term projects
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After having issued licences for new-age payments and small finance banks, the Reserve Bank of India (RBI) has now published a discussion paper on the need for wholesale and long-term finance (WLTF) banks. The idea is that as the financial sector grows, apart from a number of universal banks, it may be useful to have differentiated banks focusing on different areas and developing competence. This will reduce the cost of intermediation and lead to better economic outcomes. The discussion paper notes that WLTF banks will focus on lending to the corporate sector, small and medium businesses, and the infrastructure sector. They may also offer services in the area of foreign exchange and trade finance. Further, they can act as market makers in instruments like corporate bonds and credit derivatives. There is a gamut of specialized services that these banks can offer to Indian businesses. WLTF banks can raise funds through issuance of debt and equity. They may also be allowed to accept term deposits above a threshold.
The idea of WLTF banks is worth trying out. As specialized institutions, they will be in a much better position compared with commercial banks in evaluating and funding long-term projects. It’s not easy for companies to get long-term financing because of the underdeveloped corporate bond market and possible asset liability mismatch in the banking system.
One of the reasons for the subdued level of investment in the Indian economy is that the banking system is saddled with non-performing assets (NPAs), and a large portion is concentrated in the infrastructure sector. With specialized banks, such risks could possibly be avoided in the future. It may also help the rest of the banking sector in the case of joint lending, or by simply getting the project evaluation from these banks. Establishment of WLTF banks will also enhance competition, which will lead to more efficient allocation of financial resources.
However, there is no guarantee that WLTF banks will succeed. India has tried the development finance institution (DFI) model in the past with limited success. After independence, DFIs were established to increase the level of investment in the economy. Industrial Finance Corp. of India (IFCI) was the first such institution to be established in 1948. This was followed by the establishment of state finance corporations. In later years, other institutions like the Industrial Credit and Investment Corporation of India (ICICI) and Industrial Development Bank of India (IDBI) were established. However, DFIs struggled with government interference and changes in the economy, and accumulated high levels of NPAs. ICICI and IDBI have transformed themselves into commercial banks.
One of the biggest problems facing long-term finance institutions is competing for funds in the marketplace and being able to lend at competitive rates. A working group of the RBI on DFIs in 2004, for instance, noted: “In a purely market-driven situation, the business model of any DFI which raises long-term resources from the market, at rates governed by the market forces and extends only very long-term credit to fund capital formation of long gestation, is unlikely to succeed…. DFIs are, therefore, crucially dependent for their continued existence on government commitment for continued support.” However, government support is no guarantee of success, as has been the case with DFIs in the past and public sector banks in present times.
As the banking regulator mulls over issuing licences for new-age WLTF banks, there are at least three aspects that will need greater attention.
First, government participation in setting up WLTF banks should be avoided as it could end up defeating the purpose. Government ownership would lead to the same problems that public sector banks are facing at the moment. Further, these banks will be highly specialized and will need operational freedom, which is not possible with government ownership.
Second, licences should only be issued to entities that are able to demonstrate the ability to build such a highly specialized bank, and are in a position to bring in capital to both meet regulatory requirements and run the business on a sustainable basis. The central bank may allow industrial houses to participate to the extent that they are not in a position to influence business decisions.
Third, the RBI will need to design a regulatory architecture that will enable growth with adequate safeguards. For example, the regulator may choose to exempt these banks from cash reserve ratio and statutory liquidity ratio requirements. These banks will compete directly with the bond market.
WLTF banks will have to be designed well. With the right kind of ownership and regulatory architecture, these banks will help improve efficiency in the financial system and enhance the flow of credit to businesses with large and long-term financing needs.
Will long-term finance banks improve efficiency in the financial sector? Tell us at email@example.com