Close to two years back, on March 30 2002, the Industrial Credit and Investment Corporation of India (ICICI) was through a reverse merger, integrated with ICICI Bank. That was the beginning of a process that is leading to the demise of development finance in the country. The reverse merger was the result of a decision (announced on October 25, 2001) by the ICICI to transform itself into a universal bank that would engage itself not only in traditional banking, but also investment banking and other financial activities. The proposal also involved merging ICICI Personal Financial Services Ltd and ICICI Capital Services Ltd with the bank, resulting in the creation of a financial behemoth with assets of more than Rs. 95,000 crore. The new company was to become the first entity in India to serve as a financial supermarket and offer almost every financial product under one roof.

Since the announcement of that decision, not only has the merger been put through, but similar moves are underway to transform the other two principal development finance institutions in the country, the Industrial Finance Corporation of India (IFCI), established in 1948, and the Industrial Development Bank of India (IDBI), created in 1964. In early February, Finance Minister Jaswant Singh announced the government's decision to merge the IFCI with a big public sector bank, like the Punjab National Bank. Following that decision, the IFCI board has approved the proposal, rendering itself defunct.

It is expected that the decision would be implemented despite considerable scepticism among both PNB shareholders and IFCI employees with regard to the proposal. On his last day in office, the erstwhile Chairman and Managing Director of IFCI, V. P. Singh, sought to assuage the fears of PNB shareholders by saying that IFCI would clear most of its liabilities before the merger. Freed of them, PNB, in his view, could leverage IFCI's existing expertise on project financing, monitoring, advisory services and term-lending to complement its existing business.

Finally, recently the Parliament has approved the corporatisation of the IDBI, which had been debated for more than a year, paving the way for its merger with a bank as well. IDBI had earlier set up IDBI Bank as a subsidiary. However, the process of restructuring IDBI has involved converting the IDBI Bank into a stand alone bank, through the sale of IDBI's stake in the institution. Since there is no clear declaration that IDBI Bank would be chosen as the partner bank for the proposed merger of the DFI, talk of an alternative is very much in the air. Among the banks being mentioned are: Bank of Baroda, Punjab National Bank, Indian Bank and Canara Bank.

When the bill to corporatise IDBI was put through with some difficulty in the Rajya Sabha, it appeared that the government had provided two commitments. The first was that the government would retain a majority stake in the entity into which the IDBI would be transformed. The government currently has a 58.47 per cent stake in IDBI. And, second that the development finance emphasis of the institution would be retained. But already doubts are being expressed about the government's willingness to stick to the first of these commitments. And once the merger creates a universal bank as a new entity, with multiple interests and a strong emphasis on commercial profits, it is unclear how the second commitment can be met either.

As part of the corporatisation process, the IDBI has received a forbearance of five years with respect to the SLR requirement. It is however ready to meet the obligation of cash reserve ratio (CRR) of around Rs 2,000 crore to the RBI immediately. The SLR requirement for the institution is pegged at around Rs 18,000 crore. The non-performing assets (NPAs) of around Rs 15,000 crore are likely to be transferred out of the institution as and when the merger with a bank takes place.

These developments on the development banking front do herald a new era. An important financial intervention adopted by almost all late-industrialising developing countries, besides pre-emption of bank credit for specific purposes, was the creation of special development banks with the mandate to provide adequate, even subsidised, credit to selected industrial establishments and the agricultural sector. According to an OECD estimate quoted by Eshag, there were about 340 such banks operating in some 80 developing countries in the mid-1960s. Over half these banks were state-owned and funded by the exchequer, the remainder had a mixed ownership or were private. Mixed and private banks were given government subsidies to enable them to earn a normal rate of profit.

The principal motivation for the creation of such financial institutions was to make up for the failure of private financial agents to provide certain kinds of credit to certain kinds of clients. Private institutions may fail to do so because of high default risks that cannot be covered by high enough risk premiums because such rates are not viable. In other instances, failure may be because of the unwillingness of financial agents to take on certain kinds of risk, or because anticipated returns to private agents are much lower than the social returns in the investment concerned.

In practice, financial intermediaries seek to tailor the demands for credit from them with their funds by adjusting not just interest rates, but also the terms on which credit is provided. Lending gets linked to collateral, and the nature and quality of that collateral is adjusted according to the nature of the borrower and supply and demand conditions in the credit market. In the event, depending on the quantum and costs of funds available to the financial intermediary, the market tends to ration out borrowers to differing extents. In such circumstances, borrowers are rationed out because they are considered risky, but they may not be the ones that are the least important from a social point of view.

These problems can be aggravated because certain kinds of insurance markets for dealing with risk are absent and because in some (especially, developing-country) contexts, certain kinds of long-term contracts may not just exist. They need to be created by the state, and till such time state-backed lending would be needed to fill the gap.

Industrial development banks also help deal with the fact that local industrialists may not have adequate capital to invest in capacity of the requisite scale in more capital-intensive industries characterised by significant economies of scale. They help promote such ventures through their lending and investment practices and often provide technical assistance to their clients. Some development banks are expected to focus on the small scale industrial sector, providing them with long-term finance and working capital at subsidised interest rates and longer grace periods, as well as offering training and technical assistance in areas like marketing.

Fundamentally of course, development banking is required because social returns exceed private returns. This problem arises because private lenders are concerned only with the return they receive. On the other hand, the total return to a project includes the additional surplus (or profit) accruing to the entrepreneur. The projects that offer the best return to the lender may not be those with the highest total expected return. As a result, good projects get rationed out, necessitating measures such as development banking or directed credit.