FINANCIAL SECTOR REFORMS AND THE ROLE OF DEVELOPMENT BANKING IN THE SMALL & MEDIUM SECTOR

C.R. Rengaswamy*

In the post-nationalisation period, the banking network expanded and the financial system also developed. Yet, over a period of time, certain rigidities and weaknesses had set in. The government appointed a committee under the chairmanship of Shri Narasimham, former governor of RBI (NCR-1) to report on ways to make the financial system more competitive and efficient. The major objectives of the Financial Sector reforms in India have been to integrate various segments of the financial markets and to promote a diversified, efficient and competitive financial sector. 

The committee found out that there was a decline in the productivity, efficiency and profitability of the banking sector due to directed credit and investments. The committee also observed that the Development Financing Institutions (DFIs) are a major source of institutional support to the private sector, that there is deterioration in the quality of the loan portfolio and that the loan portfolios of DFIs, especially SFCs, are contaminated.

Restoration of health to the banking system through introduction of international standards, prudential regulations for asset classification, income recognition, provisioning requirements and adoption of (Basle Accord) Capital Adequacy norms for banks and term lending institutions were recommended by (NCR-1). The recommendations of the Committee (NCR-1) were accepted according to which the banks and financial institutional were directed in different stages to classify their assets into standard, sub-standard, doubtful and loss assets. Provision has to be made for the Non-Performing Assets (NPAs). The percentage of provisioning varies from 10% to 100% depending upon the age of the arrears and asset backing for the loan.

Capital Adequacy Ratio (CAR) of 8% was prescribed for banks and DFIs. This was to be found out after assigning risk weightage to the assets owned by the Banks/DFIs and comparing that with the equity base available The Second Narasimham Committee - (NCR II) has recommended that the CAR of banks should be enhanced to 9% from FY 2000 and to 10% from FY 2002. RBI has prescribed 9% CAR for banks as on 31.03.2000.

The NCR (I) gave importance to the profitability and productivity of the India financial system.   The report suggested cost reduction and maximisation of returns as the most important remedy for the banks. It also suggested strengthening of the qualitative aspect of lending and adopting proper standards of income recognition. It also suggested that the national and state level financial institutions should function on business principles. The Committee also suggested measures to improve money and capital markets and regulatory and control measures.

The reforms necessitated stricter controls and tightening of norms. As mentioned earlier, RBI advised DFIs to implement the Prudential Norms from 1993-94 in phases. In June 1997, credit exposure norms, which were hitherto applicable to banks, were made applicable to DFIs also. In March 1998, RBI issued directions to DFIs that necessitated prior approval from RBI for certain bonds issued by DFIs.

The first stage of reforms is over and the second stage of reforms has started in the banking sector. NCR (II) felt that the FIs should convert themselves into banks over a period of time.   Then there will be only two types of financial intermediaries - Banks and NBFCs. The Khan Working Group (KWG) has also recommended gradual elimination of the extant distinctions between banks and FIs.

The SSI sector accounts for 40% of the industrial production in the country and 35% of the total exports.  It also accounts for 80% of the industrial employment in the country. The growth of the SSI sector to this level would not have been possible without the assistance from the SFCs and SIDCs. As these State Level Development Financing Institutions (SLDFIs) operate at the grass root level, they have to be considered as an integral part of the country’s financial system. Therefore, in this essay, the role of SLDFIs is more stressed than the All India Development Financing Institutions (AIDFIs).

The DFIs were formed to assist industrial development by facilitating asset creation through long-term financing. A broad-based industrial development was considered  to be critical for the improvement of the economy. The activities of the AIDFIs are co-ordinated by IDBI. It gives refinance and other necessary support to SLDFIs and also supervises their functioning. The role of AIDFIs in the industrial development of the country is very significant. As at the end of 31.03.1999, the cumulative assistance sanctioned and disbursed by AIDFIs stood at Rs. 4,18,928.9 crore and Rs. 2,77,721.8 crores respectively.

The socio-economic objectives of the government were targeted through the AIDFIs and SLDFIs.   This includes balanced industrial growth through development of backward regions, employment generation, identification and encouragement of first generation entrepreneurs, modernisation of industries, other support services etc. The concessional  finance support from the government was available by declaring the bonds issued by the DFIs as eligible for meeting SLR requirements. The government also gave loans and equity support, offered guarantees etc. to the DFIs.

State Financial Corporations (SFCs) are the pioneers in the industrial financing activities of the state. They operate as regional development banks and help development of small and medium scale units in the respective states. As on 31.03.1999, the total loans sanctioned by all SFCs was Rs. 30,374.5 crores and the total disbursement was Rs. 24,867.8 crores. State Industrial Development Corporations (SIDCs) act as catalyst for promotion and development of medium and large enterprises in the respective states. As on 31.03.1999, the SIDCs have sanctioned Rs. 17,131.6 crores and disbursed Rs. 12,901.6 crores. Among all the FIs in the country, the total loans sanctioned by SFCs and SIDCs were Rs. 47,506.1 crores (9.12%) as on 31.03.1999.

Competition is the fallout of liberalisation. The fittest alone will have the chances of survival. This is true not only for the manufacturing sector but also for the state level and national financial institutions. With the announcement of liberalisation policy, the DFIs have been asked to function on commercial basis. 

The reforms in the financial sector have thrown open many challenges. The major one is the blurring of boundaries between DFIs and banks. Commercial banks and co-operative banks have started giving term loans. But DFIs have the expertise in term lending. At the same time they do not have the means to monitor the working capital loans, even if they extend the same to compete with the commercial banks.   Experience throughout the world suggests that the differentiation of DFIs and banks reduces the efficacy of both. It is in this context that the Khan Working Group (KWG) recommended the concept of Universal Banking which is yet to become a rule. RBI brought out a discussion paper in January 1999 on the recommendations of KWG. It highlights that the change over to universal banking should be gradual and smooth and can be considered after a period of five years. DFIs will continue to be an important source of finance for the industries till the capital market, especially the debt market is fully developed. DFIs and banks have to acquire necessary skills in offering each others‘ services.

Cash flow financing proposed by some banks as against security or guarantee preferred by the DFIs is another setback in their prospects. The competition from all quarters is likely to grow and intensify in the coming years. Banks face competition from multinational (foreign) banks. Similar threat may arise for AIDFIs and SLDFIs also. 

Share capital from government to AIDFIs has stopped. Withdrawal of this support is another challenge. Development financing role of DFIs requires concessional financing by the government.   Unlike commercial banks, DFIs do not have access to cheap funds. But we should not forget the fact that the DFIs are free from the SLR and CRR requirements that have to be complied with by the banks.

Now, the DFIs have to raise capital from the public. Thus all the DFIs are embarking on alternative sources of finance. Market borrowing and Line of Credit (LoC) from commercial banks are more expensive and the tenure will be short. This will result in mismatch of tenor if the DFIs continue their long term lending only. Spread available to DFIs is also thinning out.

In case of SFCs also, IDBI has stopped share capital contribution. Equity support from the state government is also becoming uncertain because of inadequate budgetary provisions. Again, the Khan Committee recommendation of restricting the state’s share capital to 51% has found favour with the GoI.  It is in this context that SFCs have to look out for other sources for financing such as issue of Priority Sector Bonds, LoC from commercial banks etc. SIDBI’s direct financing has affected the business of the SLDFIs.

DFIs have realised that their traditional term lending alone will not be sufficient to work on a profitable basis. They are diversifying their operations in order to have a basket of portfolio. Some of the SLDFIs have started leasing, hire purchase, bills discounting, working capital, short-term financing, venture capital, infrastructure financing etc. This diversification by SFCs will surely result in improving their bottom line but at the cost of development of the SSI sector and the development of the backward area. With the result, the avowed objective of regional balance in development will dwindle.

The presence and the role played by the SFCs/SIDCs is felt more as they assist more number of small and medium borrowers.  For the same reason, the criticism against them is also heard louder.  The provision of Section 29 in the SFCs Act, 1953 is the major target of attack. The rate of interest charged by them is another point of contention.

This is a time when eliminations of subsidy and concessions are attempted. We have to examine whether the Sick Units Rehabilitation has any meaning in the liberalised set up. If the sickness is due to the inefficiency of the promoters, the changed scenario does not warrant rehabilitation, as it would certainly mean funding of the inefficiency. Whether our country can afford to close down the unviable units need not be examined at this stage. The criticism against the SFCs, SIDCs or banks on the grounds of laxity in rehabilitation of sick units should not come from any government or governmental agency. It is for them to ensure that the policy of the Union Government on liberalisation is implemented. It is for them to spread the message among the public that inefficiency, especially in private enterprises, cannot be funded with the government money.

After the reforms, SFCs/SIDCs have become security conscious. Loans will go to already developed area and to entrepreneurs who can offer collateral security. As new industries will not come up in the backward / developing area, the existing industries in these areas will also suffer. Gradually SFCs/SIDCs will lose their identity as development financing institutions and regional imbalances will be more pronounced.

This imbalance can be corrected only if SFCs/SIDCs retain their identity. The loss of identity can be avoided only if SFCs/SIDCs are given some special treatment while applying the financial sector reforms. If NPA norms are relaxed for SFCs/SIDCs, they can partially ignore the security-oriented approach and continue the project-oriented approach. For example, loans sanctioned in the backward districts can be exempted from the NPA norms. This will in fact induce SFCs/SIDCs to sanction more loans in these regions so that the overall NPA position will improve because of the large asset base and at the same time, bad loans from the backward regions do not affect the percentage of NPAs. Regional imbalance can be overcome, if the state government provides cheap funds for exclusive financing in the backward area. If the SFCs/SIDCs are to compete with the other scores of institutions and make profit, they have to be freed from all sorts of bondage such as regional development, SSI financing, concessional financing to small loans and to weaker sections etc. One point has to be clearly understood by all concerned - that it is not possible to continue as a development financing agency of the state government and to work on a commercially viable basis.

The liberalisation and reforms have thrown open many challenges. Though the government is trying to make the DFIs function on commercial lines, it may not be able to wash them off. The DFIs have a prominent role in the development of industries and the backward region. The SLDFIs  have a very great role in the development of the SSIs. Considering the potential of SSIs and their share in the industrial production and in exports, the DFIs have also a bright future.  
 

Deputy Manager, Kerala Financial Corporation, Trivandrum 
(This essay has been awarded second prize in the Essay Competition under the aegis of COSIDICI COURIER)