CHAPTER-1

AN INTRODUCTION TO
DEVELOPMENT BANKING
 CHAPTER 1

AN INTRODUCTION TO DEVELOPMENT BANKING

Economic development is a continuous process. Broadly, there are two schools of

thought on the concept of economic development. According to some, economic
development is both the widening flow of production and deepening flow of income.
Others are of the opinion that it is the presence of various facilities that induce further
development. In fact, economic development is a socio-economic political puzzle, for it
exists within the limits set by the economic environment. Economic development is a
complex process in which both the private and public sectors have an important role to
play. Their roles are best played if they can be cast as partners in helping to achieve
growth in a given country’s economic development. The optimum scenario calls for a
mutually reinforcing partnership between all the elements of the international
development community: multilateral, bilateral, the private sector, specialized groups,
and concerned individuals- everyone is involved- all playing their roles against a
background of appropriate economic and social policies. The word “Development”
involves not merely economic changes but also social and institutional changes in many
underdeveloped countries. It calls for new sets of values and new concepts of society and
government. No path to development is likely to be smooth. Banking is the base for
economic development.

1.1 Role of Financial Institutions in Economic Development

The importance of commercial and development banks in the process of economic

development has been stressed from time to time by economic thinkers and progressive
bankers in the country. Commercial development banks play a very important role in our
economy; in fact, it is difficult to imagine how our economic system could function
efficiently without many of their services. They are the heart of financial structure of any
economy, since they have the ability to add to the money supply of the nation and create
additional purchasing power. Banks’ lending, investments and related activities facilitate
the economic processes of production, distribution and consumption.

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The readiness of financial institutions to adopt the objectives of development, economic
and social, and to bring about greater mobility of resources to meet the emerging needs of
the economy is necessary concomitant of development. It has been aptly observed: “In
India, we have taken several steps designed to make our hanking system development
oriented and to set up special institutions to give the requisite financial support to new
development in industry and agriculture, to large-scale industry and small-scale
entrepreneur. Our concern has been not only with growth but also with ensuring that the
benefits of development reach out more and more to the vast masses of the population

The success of economic development depends essentially on the extent of mobilization

of resources and investment, and on the operational efficiency and economic discipline
displayed by the various segments of the economy. At a time when the prospect of
foreign aid and assistance are dim, one has to rely upon internal resources for economic
development. It has, therefore, been rightly emphasized that the rate of investment to a
large extent depends upon the mobilization of internal savings. The mobilized savings
are employed in a productive manner, so that the economy may be on the move.

A peep into the history of economic thought adumbrates the various roles, which
financial institutions have been playing in course of their operations. These roles can be
categorized into the following:

1. Role as a Financial Intermediary

2. Role as a Catalytic Agent
3. Role as a Promoter
4. Role as a Counsellor

Role as a Financial Intermediary

Economic growth depends largely on the mobilization of resources- men and material-
and the utilization of resources in a planned way. Financial Institutions have created a
nucleus for the process of economic growth by the virtue of their task of mobilization of
the savings of general public. Financial institutions are both the repositories of the
community’s savings and purveyors of credit for economic activity. They provide to the

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saver a convenient avenue for investment of surplus funds and to the investor a source of
finance. They pool the savings of myriads of people with peculiar characteristics and
notions about safety, liquidity and profitability by means of different savings media
offering various degrees of the mix of liquidity, return and safety of the savings.

Besides representing the dichotomy between the savings and investment activities,
financial institutions help in the allocation of funds among different industries and
different sectors of the economy in consonance with the priorities laid down in a plan.
They channel savings into those industries which build a strong base for the rapid
industrialization of the country and which carry forward the phase of industrial
development. By providing financial help on softer terms to entrepreneurs setting up
enterprises in backward areas, they help in correcting regional imbalances in the country.
Further, when the programmes of rapid industrialization bogged down due to the
inadequacy of finance through the existing sources, the government can approach these
financial institutions, which render valuable assistance in the form of loans, investment in
securities and underwriting thereof.

Role as a Catalytic Agent

Financial Institutions play the role of catalytic agent to bring about economic and social
change in a country through dynamism and innovativeness in their operations. Sensing
well-established fact that development of physical and social infrastructure is essential
prerequisite for rapid economic advancement and burgeoning funds required to execute
infrastructural demand of the country. It is worth noting that funding this segment
provides exciting investment opportunities to entrepreneurs.

Besides, financial institutions can catalyze the social change, which, in fact, is imperative
for all-round economic growth of a developing country. Through introduction of special
assistance schemes for weaker and helpless sections and relatively isolated segments of
society like tribal, financial institutions play a crucial role in banishing poverty and
improving standard of living of the people.

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Through their widely spread network financial institutions make their presence felt in far
flung areas of the country, promote the habit of thrift among the people living in those
regions and help them with credit in gainful activity and join the mainstreams of
development.

Role as a Creator of Money

Financial Institutions, apart from playing the role of intermediary and catalytic agent,
create money and thus act as catalyst in the process of money supplier. Through
acceptance of public deposits and lending money against it for funding transactions they
create further deposits. This role has assumed greater importance in the present age of
consumerism with increased desire for goods and services by all segments of society.

Role as a Promoter

Entrepreneurship is one of the important sinews of economic growth of a country. One

of the serious bottlenecks in an underdeveloped country is dearth of entrepreneurship
because of social, cultural and demographic factors. So as to accelerate the pace of
growth of such country, it is imperative to assess growth potentialities of various regions
of the country in the light of natural resources, and infrastructural facilities, identify
specific project ideas, and evaluate these ideas so as to determine their feasibility in
financial and non-financial terms. This task requires considerable amount of skill,
knowledge and experience and substantial amount of finance, which is beyond the means,
and competence of entrepreneurs in underdeveloped countries. Those who have the skill
and resources to carry out such tasks are averse doing so because of the huge cost and
risk involved in the project.

As such, financial institutions play the role of a promoter to foster the economic growth
of a country. As a promoter, these financial institutions undertake comprehensive growth
potential surveys of the existing industrial structure of the various parts of the country,
analyze the trends in the demand, and supply position of the various projects, and identify
industrial ventures, which can be established in different regions in near future. Based on

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the survey, financial institutions identify need-based, resource-based and foot-loose or
merchant type industrial projects.

To ensure the proper implementation of these projects, financial institutions take the
responsibility of identifying individuals with entrepreneurial traits and motivate them to
an entrepreneurial career by providing training facilities and dispensing financial,
technical, and managerial support so that the latter may set-up industries.

Role as Counsellor

Financial Institutions also play a significant role, though indirectly, in accelerating the
pace of growth, by advising corporate enterprises on when to exit a business and how to
better manage their portfolio. Financial institutions provide useful guidance to corporate
clients about capital budgeting, capital structure, investment portfolio, identifying
potential non-performance early and expeditious remedies and foreclosure to minimise.

1.2 Financial Institutions /Development Banks: A Conceptual Framework

There is no precise definition of development bank. A development bank is a

development-oriented bank. “A development bank is thus a hybrid institution which
combines in itself the functions of a finance corporation and a development corporation.
A finance corporation is an institution which is concerned primarily with long term
capital, while a development corporation is concerned primarily with equity capital and
with fostering & managing specific companies as well as providing financial support. ” 1

D.M. Mithani has observed, “A development bank may, thus, be defined as a financial
institution concerned with providing all types offinancial assistance (medium as well as
long-term) to business units, in the form of loans, underwriting, investment and
guarantee operations and promotional activities economic development in general, and
industrial development in particular. ”

Particularly, it is oriented not only towards free economy and private sector dominated
philosophy, it finances long-term capital formation in a manner directed and related in

1 Diamond, William, Development Banks, The John Hopkins Press, Baltimore, Maryland, p.2.

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accordance with the development priorities of the country. The 20th century development
bank combines the functions of banking and development institutions. It is the
promotional aspect of the functions. Thus a development bank may be defined as “A
private and public institution, which provides promotional services and medium and
long-term finance to public or private projects, which are development (economic)
oriented and bankable. ”

Here it becomes necessary to distinguish between a development oriented project and a

bankable project.

A development-oriented project is that which fulfils one of the following objectives

generally laid down by the governments of developing countries:

1. Helps the rapid economic growth and industrialization of the economy to create
necessary climate for all-round development.
2. Earns return on investment and thus generate resources for development’
3. Promotes redistribution of income and wealth’
4. Creates employment opportunities;
5. Promotes balanced regional development;
6. Assists the development of small scale and ancillary industries
7. Promotes import substitution and helps in earning foreign exchange for the
economy.

On the other hand, a bankable project is a self-financing project which generates

enough earnings within a given period of time to:

1. The Industrial Finance Corporation of India;

2. The National Industrial Development Corporation;
3. The Industrial Credit and Investment Corporation of India;
4. The Industrial Development Bank of India or any other Financial Institutions

Financial Institutions, more appropriately designated as ‘Development Banks’ in

economic literature are a “chosen instrument for facilitating and stimulating economic

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growth.” These institutions emerged as a consequence of the special needs and
circumstances of the time. Carrying variegated nomenclatures, Non Bank Financial
Institution, Development Corporation or Development Finance Institution, such
institutions have concentrated on formulating and executing techniques of development
bank for financing industry. Development banking comes to be significantly recognized
as means of economic development in a country. “Financial Institutions need not be
passive instruments of economic activity, with dynamic management and adequate
permissive environment of available opportunities and offavorable policies, they can be
active engines of economic development (Bhatt)

A distinction is often made (by the United Nations, for instance) between a ‘development
bank’ or ‘finance corporation’ defined as an institution ‘concerned primarily with long
term loan capital’ and a ‘development corporation’, which is ‘concerned primarily with
equity capital’ and with ‘fostering and managing specific companies as well as providing
financial support. This distinction may be conceptually valid but does not have any
significance in practical life. In some cases, banks or corporations, created to invest in
both loans and equity have gradually moved, in their actual operations, to one or the other
end of the spectrum; and others, created to serve one purpose, have evolved in a quite
contrary direction, as a result of changing circumstances or shifting government policy.
Moreover, in the area between outright debt and common shares lies a broad range of
useful investment possibilities. All those possibilities can be of great importance in the
stimulation of a capital market, which is another objective of many development banks.
Although the distinction between a loan providing development bank and an equity
providing development corporation may be blurred, it does not help to point up the two
objectives common to virtually all such institutions: the provision of capital and the
provision of enterprise when either or both of those requisites of economic growth is
thought to be lacking. Though the emphasis may sometimes be on one and sometimes on
the other, the purpose of setting up a development bank or corporation is usually to
supply these two factors of production in order to speed up the process of development.
The development bank, defined as an institution to promote and finance enterprises in the
private sector, is not a new device. Such institutions have existed for centuries, which

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mobilize capital and promote productive investment. They exist today in countries as
diverse in background and circumstances as France, Chile, Puerto Rico, Turkey, India,
Malaysia, and Indonesia.
Although it is an extremely difficult task to define Development Banks. This is so
because there is tremendous diversity in their forms and often the scarce similarity in
their functions. Yet there is no dispute over the fact that the target of such development
banks is the acceleration of the rate of economic growth through speeding up the process
of industrialization and introducing a qualitative change in the pattern of investment.
Many a term is used to describe in the so- called development banks.

1.3 Evolution of Development Banks in the World

Development Banks reflect the background, situation and needs of the country in which
they appear (Diamond). Since Europe was the leader in modem economic development
the embryonic growth of banking as well as development banking emerged first in that
region of the world. Although, the development bank is a post-second World War
institutional device, it cannot be regarded as an untried innovation because prototype of
these banks had already been in existence even before World War I. The origin of such
prototype may be traced as far back as 1822, when the “Societe-Generale De Belgique”
was founded in Belgium to finance commercial and industrial ventures. With the
establishment of this institution, a vital innovation in banking technique appeared in the
world. A long period of preparation and experimentation lay behind it.1

The characteristic activities of “Societe-Generale” were to promote new industrial units,

establish financial subsidiaries and buy a considerable sum of shares of the companies
promoted and established by it. The necessary funds for the operations were obtained by
the Bank from its own paid up share capital; saving bank deposits; and sale proceeds of
bonds. The Bank promoted a number of coal mining, railway and canal companies and
formed many financial subsidiaries. In the thirties, it became the main promoter and
supporter of Belgian industry. Its activities, however, went unnoticed.

After “Societe-Generale”, the next most important prototype of a development bank of

today was the “Credit Mobiliser of France”, set up by Pereire brothers in 1852. This

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French Credit Mobiliser caught the imagination of industrial financiers throughout the
world. Indeed, it will perhaps be no exaggeration to say that in the days before World
War I, it was the only known “model” before a country which was desirous of founding
an industrial bank for financing its own industries.4 The principal object of the institution
was to function as a financing institution which would mobilize resources through the
issue of bonds and promissory notes to encourage investment in the securities of new
undertakings.5

The Credit Mobiliser promoted, financed and developed numerous industrial

undertakings at home and abroad. It created and financed railways, canals, insurance and
banking companies and issued considerable amounts of French and foreign loans. The
contribution of Credit Mobiliser in the industrial development of Europe, especially in
Germany was great.

The most important of all its contributions to economic development was the “idea of
development” and “the spirit of enterprise” which was implicit in its conception.6 This
association of the Credit Mobiliser with idea of national development gave impetus to its
success in France and elsewhere.7

Before it disappeared from the scene, it had become a model for similar investment banks
established in Germany, Austria, Belgium, Netherlands, Italy, Switzerland, and Spain.
With the adoption of the investment practices and methods of the Credit Mobiliser, the
banking system played an important role in industrialisation throughout Europe and
particularly in Germany.

In Germany, an organised pattern of banking appeared after 1853 when the “Bank fur
Handel und Industrie” was established on the pattern of Credit Mobiliser.8 After this
breakthrough in Germany, many more banks emerged and the banking system became
closely associated with industry both as promoter and financier.

In Great Britain, where the commercial banking system for providing short term finance
was present, the need for special financial institutions to provide long-term finance was
not felt until the latter part of the 19th century, when the Industrial Revolution started in

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Great Britain. There was a significant accumulation of capital derived from the
reinvestment of profits from agriculture, foreign trade and small scale industry and from
profits of lending money both to the Government and to private individuals. Moreover,
the technical innovations which called for new capital investments in even larger units
did not come abruptly to England rather they appeared in small doses. But towards the
close of the 19th century, when the size of the business units expanded and more and
more individual firms were converted into joint stock companies, the need for external
long term capital was felt,9 To cope with these new situations, the special institutions
such as issue houses, underwriters, company promoters, investment trusts etc. emerged.

In United States too towards the close of 19th century with the growth of corporations as a
form of large scale business organisation, a number of financial intermediaries appeared
on the scene to mobilise funds for investment and by the end of the century, industrial
securities began to appear on the exchange.10 It is, however, worth mentioning here that,
there was no specialized agency or institution to supply long term finance to large scale
industries of United States.

Thus, till the end of 19th century, the “Societe-Generale” and the Credit Mobiliser
continued to be the models of institutional financing in the world. They were the pioneers
in the field of industrial financing, the forerunners to all later industrial banks.11

The 20th Century Developments

In the 20th century, the prototypes of development banks started spreading their wings in
other parts of the world as well. The first example of this trend was provided by the
“Industrial Bank of Japan” which was established in 1902 on the pattern of French Credit
Mobiliser. It was the most important institutional development in industrial finance since
the establishment of the French Institution.

The Industrial Bank of Japan was created primarily for the purpose of providing long­
term finance to Japanese industry, introducing foreign capital to industry and developing
the bond market. The Bank floated and underwrote Government and municipal bonds,
subscribed to the debentures of the companies and granted loans to industrial concerns. It

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provided capital primarily for expanding, modernising and reorganising industry rather
than for launching new industries. The Government of Japan also utilized the Industrial
Bank as a medium for extending the financial assistance to small manufacturers after the
earthquake of 1923 and the panic of 1927.12

The achievements of the Industrial Bank of Japan attracted considerable notice not only
in European countries but even in backward regions of Asia and provided a model for the
setting of their own development banks.13 In India, it made a profound appeal to Indian
Industrial Commission of 1916, who were mainly responsible for popularising the idea of
forming an industrial bank in India on the model of this Japanese institution.14

After the conclusion of World War I, a large number of European countries faced the
tremendous task of economic reconstruction. This enormous task of modernisation and
development called for an adequate provision of long term industrial finance. There was a
shortage of industrial capital as never before. The type of machinery that was generally
chosen to solve this financial problem was provided by the device of the Industrial
Mortgage Bank since they had proved to be eminently successful for financing long term
operations in various spheres.15

As a result of this a number of industrial mortgage banks came to be established in

several central and eastern European countries. The largest of these were in the Industrial
Mortgage Bank of Finland Ltd. created in 1924, the National Hungarian Industrial
Mortgage Institute Ltd. set up in 1928, the Provincial Mortgage Bank of Saxony and the
National Economic Bank of Poland in 1924.

These Industrial Mortgage Banks contributed to a great extent in the reconstruction and
development of war shattered economies of their respective countries by providing long
term loans. “Even in England, the pioneer in industrial revolution, where banking
facilities were comparatively well developed and private capital was forthcoming in a
large measure for industrial ventures, the need for specialized industrial financial
institution was clearly recognized both in the inter and post-war years.”16

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The post-depression period witnessed the second phase of industrial development.
During this period, the need for catering to the requirements of small-scale industries was
also felt. Accordingly, specialised financial institutions were established in several
countries. Unlike their 19th century counterparts Mortgage Banks which were confined to
the task of lending only, these financial institutions took a keen interest in carrying out
the functions of capital underwriting and direct subscription, along with lending
functions. Some instances of such specialised institutions were the British Credit for
Industry Ltd. (1934), the Swedish industrial Credit Company (1934), the Industrial Credit
Company of Ireland, the Netherland Company for industrial Financing and Belgian
Societe National de Credit Industrial, in Italy, the Government, set up the “Institute
Mobiliare Italiano” in 1931 and the “Institute per la Ricostruzio ne” in 1933, to provide
industrial finance. Similarly in U.S.A., the Reconstruction Finance Corporation was set
up in 1932. It was entrusted with the task of checking depression by granting secured
credit to commerce, industry, agriculture etc. and accelerating output and employment in
U.S.A.

In the last phase of the industrial development observed in the years after World War II, a
new institutional device was evolved. Financial institutions emerged after World War II
showed a remarkable preference for underwriting and direct investment activity, besides
mortgage lending business. The Industrial Development Bank of Canada formed in 1944
was the first such institution.

The Canadian Government established this Bank as a wholly-owned subsidiary of its

Central Bank, the Bank of Canada. It is worth noting that this Canadian Institution used
for the first time the designation of a “Development Bank”, not familiar in those days, but
it had hardly any entrepreneurial and promotional functions which characterise most of
the development banks in underdeveloped countries today. It seems to have been
designated to provide only financing services.

In U.K. the Industrial Corporation for Industry (FCI) was set up by private banks,
financial institutions and the Bank of England in 1945 to bridge the Macmillan Gap17, the
existence of which had been pointed out by Macmillan Committee as early as 1931.

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Like the Macmillan Committee of U.K., the Royal Commission on Australian Monetary
and Banking System (1937) had pointed out that there was no institution in Australia for
providing term finance to relatively small enterprises. As a result of that, the Industrial
Finance Department was created in the Commonwealth Bank of Australia in 1946.

In U.S.A., a new kind of local and state institutions known as Development Credit
Corporations appeared to assist small concerns. They have their genesis in New England
in 1949 and soon spread to other States as well. Their principal functions were buying
and building plants for sale or lease, lending or investing funds in industrial enterprises,
giving managerial, engineering and other advisory services to small enterprises. The
tendency to set up development banks gained momentum in the post-World War II years,
not only in developing countries but also in advanced countries.

Today, development banking is a world-wide phenomenon and almost all countries in the
world have development banks. As a matter of fact, in most countries, there are a number
of development banks, some set up at the national level, some set up to meet the needs of
particular regions or States and some set up for particular sectors of the economy. In view
of the structural differences, those exist between the developed and underdeveloped
countries, the role of development banks also differs.

In economically advanced countries, the efforts in organising development banks have

been directed mainly to assist small industries. But in backward and developing
countries, the development banks have been organized to assist not only small and
medium but also large scale industries. Moreover, in these countries the development
banks concentrate on both the aspects of industrial assistance viz. “financing” and
“development”. The emphasis in case of less developed countries is more on the
development functions because the problem of promoting successful enterprise with
adequate technical know-how is acute in these countries.

It is also important to note that simultaneously with the growth of development banks at
the national level in different countries, the development banks have also been
established on the international scale to help the industrial development on a wider scale
beyond the national boundaries. At the international level we have the International Bank

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for Reconstruction and Development (IBRD) established in 1945 and its two affiliates
namely the International Finance Corporation (IFC) established in 1956 and International
Development Association (IDA) set up in 1960. Since the I.B.R.D. can grant only loans
to member governments and to private enterprises with the guarantee of the member
government concerned, the I.F.C. has been established to provide loans and risk capital to
the private sector units in the member countries without Government guarantee. The
I.D.A. has been established for the purpose of making soft loans on liberal terms with
regard to the rate of interest and the period of repayment. It is on this ground that I.D.A.
is often referred to as the “Soft Loans Window” of the World Bank.

In addition to the World Bank and its affiliates at the international level, there are
Regional Multinational Development Banks. The first to be established was European
Investment Bank in 1958 followed by Inter-American Development Bank in 1960,
African Development Bank in 1964 and Asian Development Bank in 1966. These
Regional Development Banks have been floated jointly by different countries for the
development of certain specific regions.

1.4 Genesis of Financial Institutions in India

Private Initiatives

Although, the Development Banks in India came into existence after 1947, but the
question of setting up such institutions to solve the problem of long term financing of
industries had been baffling the minds of Indian financiers and bankers since the
beginning of the present century.

The first organised attempt in this direction coincided with the spirit of Swadeshi
Movement of 1906-1319 during which a number of commercial banks mostly in the
Punjab were established to provide long-term industrial finance to the industries
spreading spirit of Swadeshi Movement. Some prominent among them were the Credit
Bank of India, the Hindustan Bank, the People’s Bank of Punjab, the Indian Specific
Bank, the Lahore Bank, the Doaba Bank and the Marwar Bank etc. to name a few.

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These banks employed their funds in channels closed to traditional commercial banking
and undertook all the various methods of investment banking. They subscribed to the
shares and debentures of industrial companies and provided advances on the security of
factories, machinery, plant and buildings etc. But many of these banks failed to bear the
agony of the financial crisis of 1913-15. The main reasons responsible for their failure
were frenzied speculation, imprudent and reckless advancing of loans, violation of
principles of investment banking and of uncarefully distributing the risk inherent in such
investment.

The second such experiment in our country began after 1918, when the post-World War I
period resulted in a climate conducive for the development of industrial banking. The
Indian economy experienced a boom period and a large number of companies were
floated. As a result of this the demand for industrial finance got increased. To meet the
situation, large numbers of banks were developed throughout the country. Like
mushrooms they began to crop up everywhere during 19 1 7-23.20 “Industrial banks
became a fashion of the day and the vogue of the times; and for some time, one heard
nothing but of industrial banks which made their debut in the North and South, the East
and West.”21 The prominent among them were - The Tata Industrial bank (1917); the
Central Travancore Industrial Bank (1919); the Indian Industrial Bank (1919); the
Calcutta Industrial Bank (1919); the Industrial bank of Western India (1919); the
Gundulpet Industrial Bank (1920); the Mysore Industrial Bank (1920); the Simla Banking
and Industrial Company (1922) and the Luxmi Industrial Bank (1923).

The Tata Industrial Bank was the largest of these banks which was established with an
authorised capital of Rs. 12 crores. It opened several branches in different cities viz.
Bombay, Calcutta, Delhi, Kanpur, Lucknow, Rangoon, Hapur, Chandausi, Dhanbad,
Hyderabad, Aminabad, Madras and Asansol. The Bank functioned successfully for less
than a decade; its achievements were no less spectacular than those of Credit Mobiliser.
But for reasons similar to those of the Credit Mobiliser, the Tata Industrial Bank went
into the voluntary liquidation in August 1923 and was amalgamated with the Central
Bank of India.

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In the same way, other banks also failed after a hectic career lasting for 3 or 4 years. The
main reasons which were considered responsible for their failure were: (i) inefficient and
inexperienced management with doubtful bona fides; (ii) imprudent and reckless lending;
(iii) unwise investment policy; (iv) mixing of short-term banking with long-term credit
business; (v) absence of proper diversification of investments and the improper and
inappropriate transplantation of German model without necessary experience and
sufficient funds.

Notwithstanding their fate, these industrial banks were the forerunners of the present
industrial development banks. At least they made the Indian industrialists to reaslise the
need for specialised institutions as an instrument of rapid industrialisation.

State Initiatives

Beside the establishment of industrial banks under private enterprise, the necessity for the
setting up of the specialized financial institutions for providing long-term industrial
finance was felt by various Commissions and Committees appointed by the Government
since the end of World War I. The appointment of the Industrial Commission in 1916
was the first organized attempt in this direction.

The Commission was expected to suggest the most profitable lines of developing the
machinery for financing industrial enterprises and the most suitable form in which the
State aid could be given to the existing and new industries. The Commission gave a
great deal of thought to the problem of financial facilities for industrial enterprises. It is
worth-mentioning that Bombay Advisory Committee was the first to suggest for the
establishment of an industrial bank in India in its evidence tendered before the Industrial
Commission. The Committee stated, “we favour the establishment of a central industrial
bank or similar organisation with a large capital and numerous branches, designed to
afford financial support to industries for longer periods and on less restricted security
than is within the power or practice of existing banks. Such a bank would probably
require a measure of government support but should not be brought under rigid
government control.”23

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The Commission made a preliminary but realistic assessment of the situation and
recommended for the establishment of special financial institutions to meet the long-term
requirements of industries in the country. For this purpose, the Commission suggested the
appointment of an Expert Committee to go into the details. In 1924, the External Capital
appointed by the Government of India under the Presidentship of Sir Basil Blackett also
pointed out the importance of a specialised system of banking and suggested for the
appointment of an Expert Committee to go into the details.

Accordingly the Government of India appointed the Central Banking Enquiry Committee
in July 1929 under the Chairmanship of Sir B.N. Mitra. This Expert Committee studied
the problems of industries in India and strongly emphasised the idea for the formation of
specialised institutions to provide long-term finance to industries.

The various Provincial Banking Enquiry Committees appointed in 1929 also stressed the
need for industrial finance and at least five of them namely the Provincial Banking
Enquiry Committees of Assam, Bengal, Bihar, the Central provinces and the United
Provinces recommended the establishment of Provincial Industrial Corporations. But no
action except a half-hearted attempt in one or two provinces was taken on their
recommendations.

The Central Banking Enquiry Committee in its report, however, recommended the
formation of Provincial Industrial Corporations, but at the same time it did not rule out
the formation of an All India Corporation. It wanted this type of institution as a
supplement to and not a substitute for proposed provincial corporations. The Central
Banking Enquiry Committee however did not work out the details for their constitution,
functions, working, limitations etc. and hence the idea could not take a practical shape.

Thus in spite of the recommendations of so many Committees and Commissions, no

action was taken for the setting up of any term financing institution and their remained
ineffective. In 1938, V.K.R.V. Rao remarked, “It is now six years since the Central
Banking Enquiry Committee and twenty years since the Industrial Commission reported
and yet nothing has been done in the matter.”24

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During the Second World War, the emphasis shifted from Industrial Banks to Industrial
Mortgage Banks. Moreover, in view of the expansion of liquid resources of Commercial
Banks owing to war and loss of the traditional sources of their income, they were urged
to forge closer links with industry. But the experience again was an unpleasant one as a
large number of these banks failed.25

1.5 Developments after Independence

Lack of adequate finance was an important factor inhibiting the industrial development of
India in the pre-independence days. There was almost a complete absent of institutional
arrangements for providing long and medium term finance to Indian industries. Short­
term finance was available from commercial banks, but that was inadequate and
cumbersome. Accordingly, soon after the independence a large number of government
owned/sponsored specialized financial institutions, such as, the IFCI, ICICI, IDBI,
SIDBI, IFCs, and SIDCs etc. were set up in the country in order to provide long term and
medium term finance to Indian industries. Simultaneously, the commercial banks in the
country were directed to reorient their policies towards greater financial assistance to
industrial units mainly in the form of short-term finance. Certain other measures also
followed in quick succession in order to reorganize the development banking industry
and to reorient its policies to meet the challenges of rising tempo of industrial
development.

The question of establishing a special financial institution, however, received the

attention of government immediately after liberation of the country. Industrial Finance
Corporation (IFC) was the first special institution established in 1948 by an Act of the
parliament with a view to making medium and long-term capital more readily available
to industrial concerns. This marked the beginning of the institutionalization process in
the country. At the time of setting up of IFC, it was recognized that it was not possible
for a single institution to satisfy the capital needs of the smaller concerns sprawling all
over the country. Accordingly, the State Finance Corporation Act was passed in 1951, to
empower the state governments to set up state financial institutions (SFCs) in their

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respective states. While the IFC limits financial help to larger industrial concerns, the
SFCs are intended to extend financial help to smaller enterprises.
One of the features that were observed in the operations of these institutions in the early
years was that they confined themselves to the lending activity and remained shy of
underwriting and investing business because of the high degree of risk involved in it. As
a result of this large number of new and smaller concerns were not able to procure
adequate capital from the market by the virtue of their weaker financial position and poor
creditworthiness. In order to fill the gap, another institution, called Industrial Credit and
Investment Corporation of India (ICICI) was set up in January 1955. Unlike IFC/SFCs,
ICICI was organized as a wholly privately owned institution.

Another milestone in the field of institutionalization of capital market was the formation
of Life Insurance Corporation in 1956 with the avowed objective of helping in the task of
national development.
In June 1958, Refinance Corporation of India was established to provide refinancing
facilities to commercial banks and other financial institutions. However it was merged
with Industrial Development Bank of India (IDBI) in 1964 when the latter assumed the
role of a refinancier as well.

During the 1960s established Industrial Development Corporation in their desire to

hasten the pace of industrial development in their respective territories. These
institutions were intended to foster industrial growth in the states by undertaking
developmental, promotional and financing functions.

However, still it was felt in every nook and comer of the country that there is an absence
of an effective mobilizing agency in the country. The Unit Trust of India (UTI), was
therefore, established in 1964 with a view to pooling the savings of the people by the sale
of its units, the purchase of which ensures to their buyers the combined benefit of safety,
liquidity and profitability and directing the resources so mobilized into newer as well as
older industrial enterprises by subscribing directly to their shares and debentures, and by
giving loan to them. UTI thus acts as a link between savings and investment.

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By this time, a plethora of financial institutions catering to the financial needs of the
industry came into fore but there was hardly any demarcation in their specific activities
which led to overlapping and duplication in their efforts with the result that some strong
concerns could manage to procure funds from a number of institutions, while weaker
concerns were left high and dry. A coordination of functions and working of existing
financial institutions was, therefore considered necessary for their fruitful contribution in
the development of the country. Besides this, existing institutions were not able to supply
funds to many gigantic projects of national importance in view of their own limited
resources. The establishment of a financial institution with a substantially larger amount
of resources and capable of functioning undeterred by statutory rigidities, therefore
become inevitable.

The Industrial Development Bank of India (IDBI), was therefore, setup as a wholly-
owned subsidiary of the Reserve Bank of India and under the direct control of it to act as
an apex institution, coordinating the functions of all other smaller financial institutions
and supplementing their resources to extend financial support to worthy projects of
national importance. With the establishment of IDBI, the control of IFC was transferred
from the government to former and IFC became a subsidiary of the IDBI. In 1976, IDBI
was further restructured and separated from the control of RBI.

Yet another, addition to the institutional finance structure was the establishment of
Industrial Reconstruction Corporation of India in 1971. This institution was set to
reconstruct and rehabilitate the sick and closed industrial units with a view to accelerating
the tempo of industrial activity in the country. In 1985, Industrial Reconstruction Bank
of India (IRBI) was constituted to act as the principal credit and reconstruction agency for
reconstruction and rehabilitation of rich industrial units. However, with the setting up of
Board for Industrial and Financial Reconstruction (BIFR), the role of IRBI become
irrelevant and Government of India receded to convert IRBI into full-fledged all purpose
development finance institution. Accordingly Industrial Investment Bank of India Ltd.
(IIBI) was set up under the Companies Act, 1956 in 1997 to provide it with adequate
operational flexibility and financial autonomy.

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In 1973, the General Insurance Corporation of India (GIC) came into being on
nationalisation of general insurance companies in the country. At present, the GIC is
functioning with its four subsidiaries namely : (1) National Insurance Company Limited,
Calcutta; (2) New India Assurance Company Limited, Bombay; (3) Oriental Fire and
General Insurance Company Limited, New Delhi; and (4) United India Fire and General
Insurance Company Limited, Madras.

In December 1986 SICICI Ltd. was promoted by ICICI together with other All-India
financial institutions, as a specialised financial institution for encouraging and assisting
development and investing in shipping, fishing and related industries. But in 1996,
SCICI was further merged with ICICI.

In view of the growing importance of small sector in Indian economy need for a separate
all-India financial institution to look after the financial requirements of small industries
was felt. Accordingly, in 1990 Small Industrial Development Bank of India (SIDBI) was
set up as a subsidiary of IDBI to take over the functions of small business financing of
IDBI.

In addition, three more specialised institutions were organised to meet the financial
requirements of certain specialised sectors. In 1988 the Risk and Technology Finance
Corporation Ltd. (RCTC) was set up by reconstituting the Risk Capital Foundation which
was promoted by IFCI in 1975 to cater to the risk capital and venture capital assistance.

In 1988 the Technology Development and Information Company of India Ltd. (TDICI)
was established by the ICICI and UTI under the Companies Act as India’s pioneer
venture finance company. TDICI was further renamed as ICICI Venture Funds
Management Company Ltd. It was established for providing assistance to small and
medium industries in the form of project loans, direct subscription to equity and a quasi­
equity instrument called conditional loan. Further, Tourism Financial Corporation of
India Ltd. (TFCI) was promoted by IFCI as a specialised financial institution to finance
the requirements of tourism industry.

-21 -
To look after the requirements of agriculture and rural sector National Bank for
Agriculture and Rural Development (NABARD) was set up in 1982 as an apex institution
for the promotion of agriculture, small-scale industries and other activities in the rural
areas. Also, for export-import sector a special financial institution Export Import Bank of
India (EXIM Bank) was established in 1982 s the principal agency for financing,
facilitating and promoting India’s foreign trade. National Housing Bank was set up in
1988 under the National Housing Bank Act as the principal agency to promote housing
finance institutions and to render financial and other support to such institutions. In
1997, Infrastructure Development Finance Corporation (IDFC) was incorporated under
the Companies Act, 1956 to provide impetus to infrastructure sector.

The major development in development banking in took place in 2001 when ICICI
(hitherto a development bank) was converted into a universal bank by Government of
India. The reason for this was given as burgeoning competition with commercial banks.
Historically, low cost funds were made available to DFIs to ensure that the spread on
their lending operations did not come under pressure. DFIs had access to soft window of
Long Term Operation (LTO) funds from RBI at concessional rates. They were also
allowed to issue bonds, which qualified for SLR investment by banks. For deployment of
funds they faced little competition as the banking system mainly concentrated on working
capital finance.

1.6 Emerging Indian Scenario

India has historically, followed a financial intermediation-based system where banks,

DFIs and other intermediaries have played a dominant role. However, in recent years
resources are increasingly being mobilised through capital markets (both debt and
equity). With the progressive blurring of functions between banks and financial
institutions, the AIFIs are fast losing ground and adopting the business model of a bank to
remain viable in the long run. The merger of ICICI with ICICI bank on March 30, 2002
was the beginning of conversion of AIFIs into universal banks. Taking into account the
changing operating environment following the initiation of economic reforms in the early

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1990s, the Government decided to transform IDBI into a commercial bank without
eschewing its traditional development finance obligations. The migration to the new
business model of commercial banking, with its access to low cost, current/saving bank
deposits is expected to enable it to overcome most of the limitations of the current model
of development finance and also to diversify its client/asset base. In fulfilment of these
objectives, the IDBI (Transfer of Undertaking and Repeal) Act, 2003 was enacted in
December, 2003, which came into effect from July 2, 2004. The Act provides for repeal
of the IDBI Act, corporatisation of IDBI, and its transformation into a commercial bank.
IDBI was transformed into IDBI Limited on October 1, 2004, a company under the
Companies Act, 1956 and a schedule bank (on October 11, 2004) under the RBI Act,
1934. In a parallel move, the Government approved IDBI’s proposal to set up a Stressed
Assets Stabilisation Fund (SASF), which provides for stressed assets of IDBI amounting
to Rs. 9,000 crore to be transferred to SASF against an equivalent amount of 20 years’
bond issued by the Government of India in favour of SASF on cash/budget neutral basis.
On July 29, 2004, the proposal to merge IDBI Ltd and IDBI Bank was accorded in
principle approval by the respective Boards. With the reverse merger of ICICI with ICICI
Bank in 2002 and conversion of IDBI into a bank, the importance of AIFIs in the
provision of project finance has come down considerably.

Taking into account the difficulties faced by AIFIs in the changed operating environment,
the RBI constituted a Working Group on Development Financing Institutions with Shri
N. Sadasivan as its Chairman. The Working Group submitted its report in May, 2004
suggesting a roadmap for development financing and the role of DFIs. The main
recommendations made by the Working Group relate to conversion of DFIs, which are
inherently unsustainable, into either a bank or an NBFC, strengthening of regulatory
framework, raising of risk weightage of certain categories of investment from 20 per cent
to 100 per cent and extension of certain relaxations for DFIs for converting into banks for
a period of 3 to 5 years after their conversion.

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1.7 Present Structure of Development Banking In India

Today, a well-knit structure of over 60 financial institutions, comprising 15 institutions at

the national and 47 institutions at the State-level, meets the vital long-term financial
needs of the fast growing industrial sector in the country. These 15 All-India Financial
Institutions (AIFIs) comprise six All-India Development Banks (AIDBs), two Specialised
Financial Institutions (SFIs) and seven Investment Institutions. The six AIDBs are
Industrial Development Bank of India (IDBI), IFCI Ltd., ICICI Ltd. (erstwhile DFI since
converted into a bank), Industrial Investment Bank of India Ltd. (IIBI), Infrastructure
Development Finance Company Ltd. (IDFC) and Small Industries Development Bank of
India (SIDBI). The SFIs comprise Export-Import Bank of India (Exim Bank) and
National Bank for Agriculture and Rural Development (NABARD). The seven
Investment Institutions comprise Life Insurance Corporation of India (LIC), General
Insurance Corporation of India (GIC), National Insurance Company Ltd. (NIC), The New
India Assurance Company Ltd. (NIA), The oriental Insurance Company Ltd. (OIC),
United India Insurance Company Ltd. (UII) and Unit Trust of India (UTI) (reorganised,
effective February 1, 2003). For the purpose of discussion and further analysis the above
institutions, together with 28 State Industrial Development Corporations (SIDCs), 18
State Financial Corporations (SFCs) and North Eastern Development Finance
Corporation Ltd. (NEDFi) have been grouped as AFIs.

The functions of all these development banks are wide ranging and cover promotional
and developmental activities in addition to the main activity of financing of industrial
projects and programmes. Besides, a chain of Technical Consultancy Organisations
(TCOs) provide a wide range of consultancy services to small and medium enterprises at
reasonable cost.

AFIs cater to the needs of industrialists at national level as well as at state level both
individually as well as a part of consortium. The State-level institutions (SIDCs and
SFCs) were set up to supplement the efforts of AIFIs as also to give focused attention to
the development needs of their respective States. While SIDCs cater to medium and
large-scale industries, SFCs provide assistance mainly to small and medium enterprises in

- 24 -
their respective States. Apart from providing financial assistance financial institutions
also undertake promotional and development activities. NEDFi provides an assortment
of financial and promotional support services, including entrepreneurship development
programmes, for economic development of the eight States of the North-East.

1.8 Financial Products (Project Finance) offered by FIs in India

AFIs have played a prominent role in fulfilling the mission of promoting industrial
growth through financing of medium and long-term projects, in consonance with national
plans and priorities. Over the years, various financial institutions have enlarged their
basket of products and services, covering almost the entire spectrum of industrial
activities, including manufacturing and services. AFIs provide financial assistance, both
in rupee and foreign currencies, for green-field projects as also for expansion,
modernisation and diversification purposes.

In the wake of financial sector reforms unveiled by the Government since 1992, FIs
evolved an array of fund and fee-based services with a view to providing an integrated
solution to meet the entire gamut of financial and corporate advisory requirements of
their clients. These financial institutions also provides indirect financial assistance by
way of refinancing of loans extended by State-level financial institutions and banks and
by way of rediscounting of bills of exchange arising out of sale of indigenous machinery
on deferred payment terms. The product range of financial institutions comprises of
following credit products:

1. Short-term Loans (upto two years) for different short term requirements including
bridge loan, Corporate Loan etc.
2. Medium-term Loans (more than two years to eight years) for business expansion,
technology up-gradation, R&D expenditure, implementing early retirement
scheme, Corporate Loan, supplementing working capital and repaying high cost
debt.
3. Long-term Loans (more than eight years to upto 15 years) - Project Finance for
new industrial/ infrastructure projects Takeout Finance, acquisition financing (as

-25 -
 per extant RBI guidelines / Board approved policy), Corporate Loan,
Securitisation of debt Structured Products: acquisition finance, pre-IPO
investment, IPO finance, promoter funding, etc.
4. Lease Financing
5. Takeover of accounts from Banks / Financial Institutions / NBFCs
6. Financing promoters’ contribution (private equity participation)/subscription to
convertible warrants
7. Purchase of Standard Assets and NPAs

The product mix offering varies from one business/ industry segment to another. The FIs
tend to customize the product-mix to maximize customer satisfaction. The domain
knowledge and innovativeness of a financial institution helps in making a tailored made
product-mix for building enduring and sustaining relationship with the borrowers.

1.9 Targeted Business Segments

Traditionally, AFIs have been meeting the changing requirements of the clients by
endeavoring to devise various schemes and financial products for multiple industry
sectors. Major Financing Schemes of AFIs included Project Financing and Financial
Services mainly to the manufacturing industry along with a diversified industrial
portfolio.

1. Public Sector Undertakings

2. Manufacturing industry
3. Infrastructure projects

a. Power
b. Airports (Brownfield)
c. Ports
d. Hotels
e. Urban infrastructure projects

26
- -
 4. NBFCs
5. Participation in Private Equity Promoter funding

Over the years, the importance of project financing has increased manifold all over the
world and our country is also not an exception to it. The next chapter discusses the
meaning, importance, limitations and various types of project financing techniques
prevailing in our country.

- 27 -
 References

Diamond William, “Development Banks”, The Johns Hopkins Press, Baltimore,

Maryland, 1957, p. 32.

2 Ibid

3 Simha, S.L.N., “Development Banking in India”, I.F.M.R. Publication, 1976, p. 2.

4 Basu, S.K., “Industrial Finance in India”, Calcutta University Press, 1953, p. 247.

5 Ibid

6 Cameron Ronode E., “The Credit Mobiliser and the Economic Development of
Europe”. The Journal of Political Economy, Vol. LXI, No. 6, Dec. 1953, p. 486.

7 Diamond William, op. cit., p. 23

8 Maitin, T.P., “Institutional Financing in India”, 1971, p. 46.

9 Ibid., p 19-20

10 Ibid., p. 28.

11 Basu, S.K., op. cit., p. 245.

12 Allen, G.C., ‘A Short Economic History of Modem Japan”, London, George Allen and
Unwin, 1950, pp. 101-102.

13 Basu, S.K., “The Theory and Practice of Development Banking - A Study in the Asian
Context”, 1965, p. 4.

14 Basu, S.K., “Industrial Finance in India”, p. 251.

15 Basu, S.K., “Theory and Practice of Development Banking”, pp. 5-6.

16 Simha, S.I.N., op. cit., p. 2.

17 Norman Maerae, “The London Capital Market”, The Staples Press, 1955, p. 122.
I&
Diamond William, op. cit., pp. 30-31.

19 Basu, S.K., “Industrial Finance in India”, p. 114.

-28 -
20 Ibid., p. 119.
21
Statement of Evidence submitted by the Editor of Indian Finance - “Indian Central
Banking Enquiry Committee”, Vol. II, p. 192.

22 Report of the Indian Industrial Finance in India”, p. 114.

23 The Bombay Advisory Committee quoted by the Industrial Commission, 1916-18, p.

214.

24 Ibid

25 Sharma, T.R. and Chauhan, S.D.S., “Indian Industries”, 1962, p. 312.

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