impact of Development Banks on Economic growth & development

It is argued that development banks are important because they fill the gaps left by private financial institutions, which are mostly geared towards commercial activities. The main gap that a country is usually faced with is insufficient finance for economic transformation. Economic transformation typically requires long-term finance for large-scale projects with long maturation periods, which ultimately translates into risks that other banks are unwilling to undertake and would rather avoid.

A development Bank is a national or regional financial institution designed to provide medium and long-term capital for productive investment. They finance development in all its senses, whether infrastructure projects or industrial projects, usually at the larger end of the scale; and is often accompanied by technical assistance, in poor countries. 

Development banks are seen as an important tool to solve market imperfections that would leave either profitable projects or projects that generate positive externalities without financing (Bruck 1998, Yeyati, Micco and Panizza 2004). In economies with significant capital constraints, these banks serve to alleviate capital scarcity and promote entrepreneurial action to boost new or existing industries (Armendáriz de Aghion 1999, Cameron 1961). They also lend to companies that would not undertake projects if not for the availability of long-term, subsidized funding from a development bank (Rodrik 2004, Yeyati, Micco and Panizza 2004). These positive effects notwithstanding, development banks—and state-owned banks more generally—are often criticized for supporting politically connected industrialists (Ades and Di Tella 1997, Faccio 2006, Hainz and Hakenes 2008, La Porta, Lopez de Silanes and Shleifer 2002) or crowding out private sources of capital that would otherwise help promote new investment (Antunes, Cavalcanti and Villamil 2012, Lazzarini, Musacchio, Bandeira-de-Mello and Marcon 2015).  

Surprisingly, despite this controversy, empirical research on development banks is scant. Most of what we know about these banks is based on descriptive or theoretical work, rather than on empirical studies of the tools that they use and the effects of their actions (Amsden 1989, Armendáriz de Aghion 1999, Aronovich and Fernandes 2006, Bruck 1998). Yet, development banks remain important players in many countries, developed and developing alike. Musacchio and Lazzarini (2014) identified 286 development banks throughout the world, chiefly concentrated in South and East Asia (29.7%) and Africa (24.5%), followed by Latin America and the Caribbean (17.8%).  In this study we are particularly interested in the so-called state-owned development banks, which are owned by particular domestic governments (different from multilateral institutions such as the World Bank) and usually have a mandate to promote local industrial development.

More specifically, our objective is to discuss distinct market failures addressed by state owned banks and how these market failures map onto different policy tools that have been used by the banks. For instance, some development banks use direct lending to reduce information asymmetry and rationing in credit markets, while other banks use credit guarantees (without direct lending) for the very same purpose. Our empirical analysis is based on the comparative assessment of six state-owned development banks in different regions of the world: Chile’s Corporation for Promotion of Production (Corfo); the Brazilian Economic and Social Development Bank (BNDES); the Business Development Bank of Canada (BDC); Germany’s KfW; the Korean Development Bank (KDB); and the China Development Bank (CDB). Based on this comparative assessment and evidence of the impact of their programs, we then generate policy recommendations to help improve the industry- and firm-level performance implications of state owned development banks.

Difference between Development Bank and Others

Commercial banks: Make short-term loans, money transfers, buy and sell foreign exchange, and they deal in derivatives. Most of their loans are for periods of less than a year.

Investments banks: Specialise in raising long-term funds in financial markets through underwriting and issuing of securities.

Development banks: like investment banks, operate in the field of long-term finance. Their core business is to extend long-term loans for financing projects and development programs. Over time, development banks assume investment bank functions as well. Development banks give priority to financing projects that yield substantial economic, social and environmental benefits. They also provide technical assistance to improve the quality and reduce the risks of projects.

Development banks must change over time, more rapidly than commercial and investment banks as they must stay ahead of, and prepare for expected change. 

Different Level of Development Banks.

National Development Banks

A National Development Bank is a finance institution, created by a country’s government that provides financing for the purposes the country’s economic development.

At the national level, development banks can be instrumental not only in addressing market failures, such as the lack of provision of long-term finance due to the risks and uncertainties involved, but as a critical tool in supporting a proactive development strategy.

In addition, such banks provide both lending and equity participation, meaning that they have a clear interest in the close monitoring of projects, thus developing a special form of relationship banking.

Regional development banks

Regional development banks can also help mitigate informational deficiencies facing the private sector by providing a share of screening, evaluating and monitoring and, where needed, their own money, thus partnering with private investors in co-financing. A partnership between regional development banks and the private sector may take different forms. For example, regional development banks may provide long-term lending, while the private sector provides more short-term resources, or the former may provide a guarantee to cover regulatory and contractual risks, while the latter covers market risks. Regional development banks, in addition, can help address the need for low-income countries to have access to loans for financing infrastructure projects at subsidized rates.

Development banks are a key source of long-term finance in Africa. The banks do however possess a limited capacity to provide finance for large development-oriented projects on a scale that meets the needs of their respective sub-regions.

Theory of Development Bank

Development banks are financial institutions typically offering subsidized, long-term financing for industrial development. Although there are many multilateral development banks focusing on distinct areas and countries, our emphasis here will be the so-called “state-owned” development banks, controlled by a local government. The tools employed by each bank vary, but in general include medium- to long-term credit, subsidized interest rates, credit guarantees, equity, and technical assistance. While it is widely understood that development banks target industrial production, intense discussion exists around the methodologies employed by each bank and the motivation behind them (Lazzarini, Musacchio, Bandeira-de-Mello and Marcon 2015). From the vast body of literature encompassing this discussion we identify three main views on the purpose and role of development banks: the industrial policy view, the social view, and the political view (Musacchio and Lazzarini 2014, Yeyati, Micco and Panizza 2004). 

In brief, the industrial policy view holds that development banks were formed in response to failures of the capital markets to provide the financing necessary for entrepreneurial activity and industrialization (Armendáriz de Aghion 1999, Gerschenkron 1962). The social view holds that the government intervenes in the capital markets to address specific social issues (i.e., unemployment, lack of housing, energy dependency, etc.) (Shapiro and Willig 1990, Shirley

1989). The political view depicts development banks largely as instruments serving politicians’ personal objectives or as conduits for rewarding politically involved industrialists (Ades and Di Tella 1997, Shleifer and Vishny 1994). Each view presents a different perspective on the role of government (through the bank) in addressing market failures. Similarly each view lends itself to a different set of expectations regarding which financial instruments are best able to achieve the specific objectives and the effects that would be seen in the subsequent impact metrics.  

Industrial Policy View

The industrial policy view, as the name might suggest, is built on the assumption that industrialization—and entrepreneurial activity more generally—will lead to economic growth in a country and subsequent improvements in overall welfare. In this view, capital market constraints are seen as the prohibitive factor to entrepreneurship, often directly, but also indirectly as financing for the infrastructure necessary to support industrialization may also be seriously deficient. 

The direst constraint here is a lack of long-term lending not only for large industrial and infrastructure projects (Gerschenkron 1962), but also for the new ventures needed to bear the costs of discovery of new technologies and productive processes (Hausmann and Rodrik 2003). Additionally, information asymmetries and the inherent riskiness of such projects result in high interest rates deterring otherwise willing investors. High information asymmetry is most severe in the case of small investors seeking capital from the private sector. Medium- to long-term loans null the duration constraint on financing, while government funding for development banks provides lower-than-market interest rates essentially subsidizing the cost of the infrastructure or industrial projects. Development banks have also deployed equity financing in support of both state-owned enterprises (SOEs) and private firms; however this has been seen to be an effective use of state capital only in the case of credit-constrained firms (Inoue, Lazzarini and Musacchio 2013). To leverage the capabilities of the private sector, banks often have specialized structures to identify potential projects and even in some cases offer technical assistance (Armendáriz de Aghion 1999). In addition to patient capital, development banks may also offer guarantees, which serve to unlock additional capital from the private sector for development projects (Riding and Haines Jr. 2001, Zecchini and Ventura 2009). 

Government intervention, under the industrial policy view, is largely seen as positive. The direct benefit then lies in enabling the country’s industrial sector to unleash latent capabilities and thereby increase productivity and competitiveness (Rodrik 2004). The main insight of this view is that these latent capabilities are either too risky to be developed through the private financial system or too difficult to recognize. Indirect benefits of government involvement through development banks and the subsequent industrialization include creation of new streams of employment (through funding labor-intensive infrastructure projects), infrastructure projects with positive externalities (such as creation of new roads or water sources), and extending capital markets to support entrepreneurial activity. Proponents of the industrial policy view also cite increased investment in innovation and discovery as a key benefit of development banks. As entrepreneurs develop new capabilities, they generate learning externalities that subsequent firms could imitate or upon which they could build. The presence of those externalities, some argue, will likely lead to underinvestment in new private capabilities (Amsden 1989, Hausmann and Rodrik 2003). Additionally, development banks can promote coordination to develop projects that require the orchestration of many actors and/or sectors (Murphy, Shleifer and Vishny 1989). Typically, this is the case of large, complex infrastructure projects or projects that require building local supply chains. 

A controversial issue that is defended by some proponents of industrial policy is the socalled role of banks in supporting strategic trade. Throughout the world, banks have created “national champions” with heavy use of subsidies and even market protection (Fogel, Morck and Yeung 2011). In a context of global competition, firms that are heavily subsidized tend to distort markets and create negative externalities for competitors that lack those subsidies. Although these distortions are increasingly condemned by the World Trade Organization (Buiges and Sekkat 2009), government support for export activities and international expansion remains widespread. Development banks have also been used to support the strategic expansion of global firms, especially in contexts in which competition is heavily affected by nonmarket policies.

Social View

In this view, the development bank will try to leverage its competitive financing to ensure that firms recognize their roles in contributing to social issues, adopting sufficient constraints on activities contributing to the worsening of these issues and implementing initiatives to reduce or reverse the negative impact. In this regard, like any other state-owned policy bank, a development bank may actually finance projects with negative net present value but which offer significant positive externalities on the social side (Shapiro and Willig 1990, Yeyati, Micco and Panizza 2004). 

Long-term, subsidized debt financing is an important tool of the development bank in promoting this focus on social issues. In particular, the duration and subsidies incentivize socially beneficial projects with either too long a time horizon or capital costs too high to insure the hurdle rates of investors are met. Equity financing, in turn, may be deployed to finance the establishment and growth of firms with a primary objective of addressing relevant social issues; this may include funding a new venture in an underdeveloped region or financing the expansion of firms with significant job creation potential. There is some evidence that development banks do care about creating new employment, regardless of the productive structure of the new jobs (De Negri, Maffioli, Rodriguez and Vázquez 2011). Both through debt-financing terms and equity, development banks may make funds available to a firm contingent on prioritization of various social objectives. 

Political View

The political view presents a more negative perspective on industrial policy as a whole. Under the political view, the investment criteria for development banks are shifted from alleviating gaps in the capital market or directing financing towards social aims to funding the preferred projects of politicians. These projects may lack the objectives laid out in the industrial policy and social views. The result is misallocation of funding which leads to distortions in the financial and labor markets. There are two hypotheses as to how this misallocation occurs: the soft-budget constraint hypothesis and the rent-seeking hypothesis.

The soft-budget constraint hypothesis is fairly straightforward and surmises that under the political view, development banks are used to “bail out” failing firms (Kornai 1979). In contrast to the industrial policy view that presents government subsidies as productive for investment and development, here the subsidy, guarantees, and/or long-duration lending serve to direct funds to inefficient market players rather than efficient firms. This subverts capital that could be used more productively and weakens incentives for firms to reach the industrial and/or social objectives laid out under the other two views (Shleifer and Vishny 1998). 

The rent-seeking hypothesis presents a slightly more nuanced form of misallocation. Under the policy view the subsidies and long-term lending, which under both the industrial policy view and the social view enable development banks to facilitate optimal productive investment, are instead subverted to projects that are not inhibited by gaps in the capital markets. The funded projects could access capital from investors in the private markets, but through “cronyism,” a behavior that rewards political supporters with easier access to government resources or inversely enables high-powered industrialists to benefit from strategic political leveraging, industrialists are able to access the more competitive terms of the development banks’ loans (Ades and Di Tella 1997, Claessens, Feijen and Laeven 2008). 

In the presence of rent seeking, a primary recommendation from the literature is to establish clear targets for the policy objectives, monitor the performance of investments, and cease support if firms fail to meet the objectives (Amsden 1989, Lazzarini 2015, Rodrik 2004). Absent of these controls, development banks may end up providing capital to low-productivity firms or firms that do not need subsidized capital in the first place (Cull, Li, Sun and Xu 2013, Lazzarini, Musacchio, Bandeira-de-Mello and Marcon 2015). In other words, while banks can reduce market failure, they may also create government failure, that is, policies that end up reducing welfare and efficiency (Coase 1960, Krueger 1990).

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