The label “development bank” attaches to a group of national financial institutions, in developing countries, that vary widely in size, source of funds, and scope of activity. Essentially, a development bank is a vehicle for mobilizing and channeling medium- and long-term capital into the productive sector of the economy; most are also a source of entrepreneurship and technical assistance. Some development banks create and finance public enterprises or plan or carry out national development programs, but these are the exception; typically, the term “development bank” describes an institution created to encourage the growth of the private sector. Although limitations of funds and of qualified personnel have led countries in an early stage of development to entrust to their development banks responsibilities in several fields—agriculture, industry, housing, mining—emphasis on a single field is more usual. Among these specialist institutions the greater and the growing number are concerned with industry, and it is these that best illustrate the possible range of a development bank’s operations.
Among industrial financing institutions may be found not only public banks but a number of banks that are privately owned, wholly or predominantly. Banks that extend agricultural credit or are actively engaged in promotional work, however, are normally government owned. These activities are relatively risky, expensive, not immediately revenue producing, and hold little appeal for private investors. In countries with a low level of domestic savings and limited access to external sources of finance, any private participation in a development bank is likely to be no more than token, at least initially. Sometimes even in countries with a relatively high savings ratio, when government policy has called for support of the private industrial sector, the government will choose to create a public development bank as a vehicle for its assistance. In any event, a benevolent government interest is essential to a development bank’s success, and most banks function in the context of a national development plan.
The antecedents of the modern development bank can be traced back some hundred years to industrial financing institutions in Europe and the United States (Diamond 1957, pp. 19–37; Institut d’Etudes Bancaires et Financieres 1964, pp. 49–66). Since the 1950s the number of development banks has increased rapidly, as developing countries have sought mechanisms to accelerate their economic growth and especially to stimulate industrialization. Tallies vary, depending on definition; moreover, they are soon outdated, as new banks come into operation; in 1964 there were well over one hundred, to be found in all parts of the less-developed world. The International Bank for Reconstruction and Development and its affiliates, the International Finance Corporation and the International Development Association, have encouraged the creation of private development banks in appropriate circumstances, extending both technical assistance in their establishment and operation (including recruitment of management and training of staff) and financial support (amounting to about $300 million by mid-1964) through loans or participation in share capital. Assistance has also been provided by the Inter-American Development Bank and through the aid programs of industrialized countries. The United States by mid-1964 had committed about $1,000 million to various types of development banks. The United Kingdom and France have a long history of extensive assistance to such institutions, the former concerned with banks in Commonwealth countries, the latter with those in former French Africa. Germany and Japan have entered the field more recently. The development bank has served as a means of retailing funds—often foreign exchange—to enterprises too small to be financed directly by these public sources.
Development banks are intended to fill a gap primarily, though not exclusively, financial. Commercial banks, traditionally, have not made available investment capital; they generally provide short-term money only, frequently at a high rate of interest, and tend to favor existing enterprises and the larger borrowers. Savers in the typical developing country prefer investments promising a quick return to those offering only the prospect of gradual growth; they would rather invest in commercial ventures or real estate or send funds abroad than participate in untried industrial enterprises. The financial institutions and capital market mechanisms that in more developed countries serve to transfer savings are absent, embryonic, or inefficient. Often the business community shows little inclination to look for new fields of activity or even to act when promising opportunities are called to its attention. Finally, the organizational and technical competence to launch and sustain a new enterprise is frequently lacking or in short supply.
A development bank appropriately capitalized, well managed and staffed, and free to reach investment decisions objectively on business and economic grounds can help to overcome these various difficulties. It can supply investment capital—loan or equity or some intermediate form—from its own resources and can recruit capital from other sources, domestic and foreign. It can encourage and facilitate direct investment in industrial securities and help to develop a capital market. It can spark industrial initiative, sponsor urgently needed new ventures, and provide advice at all stages of a project, from planning to operation.
Each bank is, or should be, designed with a particular country’s needs and environment in view. In consequence, there is no model for a development bank, and no single description adequately fits them all.
Capitalization. Private development banks are organized as corporations, some with several hundred million dollars of initial capital, some with far less. The capitalization of any particular bank necessarily reflects a judgment concerning the amount that it appears feasible to raise from available sources. A second relevant consideration is the desirability of launching the bank with resources large enough to assure an impact on the economy and, assuming the bank is soundly run, earnings sufficient to cover operating costs, reserve and tax requirements and, before too long, payment of a modest dividend. Usually, institutional shareholders—commercial banks, insurance companies, investment houses—predominate. Many institutions in the industrialized countries have invested in development banks, primarily to obtain a window on events in a country to which they have some special tie or in the expectation that the bank will ultimately prove beneficial to their own interests. Foreign shareholders serve as a channel for the managerial skills and modern technology so scarce in developing countries and also help the bank to resist any undue local political pressure.
It has proved harder to attract individual shareholders, at least in the early stages of a bank’s operations; they tend to have a greater concern for the probability of an adequate return on their investment. A successful development bank can be expected to earn moderate returns in time; none is likely to be highly profitable. Individual investors have, however, been attracted by the inducement of special government assistance in a bank’s initial capitalization. The most effective device has been a long-term loan, interest-free or at low interest, subordinate to share capital in the event of the bank’s liquidation. Earnings on the no-cost or low-cost funds enhance the return on equity; the subordination to equity provides shareholders with a cushion against losses. Some governments have permitted a development bank to manage public funds for a fee and without risk, or have extended special rediscount or borrowing privileges, granted preferential tax treatment for dividends, or guaranteed a minimum dividend. Development-bank loan capital has come primarily from public sources at home or abroad; a few banks have borrowed in the local capital market with a government guarantee.
Operation and policies. Normally, a development bank tries not to compete with other sources of funds, particularly the commercial banks. This is one reason why most development banks do not accept deposits and, in fixing their loan charges, take into account not only their own cost of capital but also the going rate of interest. Compared with commercial banks, the development bank gives greater weight in its investment decisions to growth potential and quality of management and places less emphasis on security and credit standing. As a development agency, the development bank is mindful of the needs and preferences of applicants and the potential benefit of a proposed investment to the economy. At the same time, if it is a shareholder-owned institution, it cannot ignore the source and cost of its own capital and the composition of its investment portfolio and must therefore take profitability into consideration (Boskey 1959, pp. 49–55).
Although development banks finance the modernization or expansion of established enterprises as well as the establishment of new enterprises, their characteristic willingness to take risks and to combine development and banking criteria in investment decisions makes them particularly useful to the latter; new enterprises cannot readily borrow in the market and have limited earnings to reinvest. Equity financing is frequently most appropriate for such enterprises: unlike a loan, it imposes no interest or repayment burden. But the bank is not always welcomed as a co-owner. Family-held enterprises are sometimes reluctant to admit outsiders to ownership; this may be particularly true where the bank is a government institution. Moreover, the banks take their own investment portfolios into account in determining the nature of their financing; they generally limit equity holdings to the equivalent of their own share capital plus reserves.
A development bank does not usually extend either very small or very large loans. Appraisal, administration, and follow-up of small loans is costly and time consuming; the loans themselves are risky. Unless the bank is a public institution with no pressure to pay dividends or has special funds for assistance to small enterprises, it normally excludes such enterprises from its clientele by setting a minimum on the size of individual investments. For different reasons—to diversify its portfolio and avoid allocating an unreasonably large proportion of resources to a single project— the bank usually sets a ceiling on the amount of financing to any one client. Thus, development banks usually do not cater to very large projects either, except as partners or participants with other investors (such as the International Finance Corporation). Normally, a bank will supply no more than half of an applicant’s financial requirements; this mobilizes capital in support of the bank’s contribution and spreads the impact of its financing.
There are a number of ways open to a development bank to assist the growth of a capital market and to encourage the practice of industrial investment. When enterprises financed by the bank have “seasoned” and begun to show a profit, the bank may sell their securities from its portfolio. This adds to the supply of marketable securities in circulation and broadens industrial ownership and the base for future sales; in addition, it releases the bank’s resources for new investments. The bank may underwrite new securities, normally only those issued by enterprises it has itself financed. It may offer participations in its investments and issue its own obligations. Each of these activities in effect invites investors to rely on the bank’s appraisals and investment decisions. Consequently, the extent to which a development bank can be successful in these areas depends upon the extent to which it has been able to establish a reputation for sound business judgment. Finally, the bank may be an educator and innovator, introducing or making more familiar financial instruments and techniques employed in the capital markets of industrialized countries.
Role in stimulating investment. The development bank’s promotional role—the stimulation of new industrial investment—is an important one. At the same time, since promotion is likely to be expensive and unlikely to produce immediate returns, private banks can afford only limited activity of this character unless they have special resources for the purpose. The possibilities are varied. Through its own staff or contacts available to it, the bank can help to translate an idea into a bankable project and a project into an operating enterprise. The bank’s analysis, in the regular course of business, of proposals submitted to it may lead to suggestions for modifications in the financial, economic, technical, or managerial aspects, rendering the proposal more economic and technically sounder. The bank may find experienced industrial partners for new and complex undertakings. It will try to bring investment opportunities and private capital together. It may conduct a survey of a geographic region or an economic sector to find promising projects. It may actively sponsor, and establish in cooperation with other sources of capital and technology, new enterprises to meet specific needs of the economy. Once the bank has financed an enterprise, it provides continuing guidance to its clients on matters of operation and policy. By encouraging the adoption of good financial and managerial practices, it can help to create and maintain a sound industrial sector.
Although the development bank is a useful and versatile instrument of economic development, it is only one of many; it cannot by itself overcome the host of problems that developing countries encounter on the road to industrialization. Moreover, certain conditions are a prerequisite to the success of any development bank. Before a bank is created the needs it is to meet should be identified, to facilitate formation of an appropriate organization and financial design. For a private institution to be profitable, there must be within the country enough of the basic ingredients of industrialization to assure a continuing flow of a fair volume of business. There should be at the outset experienced management and a competent and sufficiently numerous staff; often this will mean some foreign personnel initially, a circumstance which developing countries, especially those newly independent, sometimes find hard to accept. Finally, realization of a development bank’s potential requires government policies—fiscal, monetary, commercial—that support and facilitate the bank’s activities and that, in particular, create a climate congenial to private enterprise. Experience indicates that it is a waste of scarce development resources, both of funds and personnel, to create a development bank where these conditions cannot be, or are not, met.
[See alsoEconomic Growth.]
Adler, Robert W.; and Mikesell, Raymond F. 1966 Public External Financing of Development Banks in Developing Countries. Eugene: Univ. of Oregon, Bureau of Business and Economic Research.
Boskey, Shirley 1959 Problems and Practices of Development Banks. Published for the International Bank for Reconstruction and Development. Baltimore: Johns Hopkins Press.
Diamond, William 1957 Development Banks. Published for the International Bank for Reconstruction and Development, Economic Development Institute. Baltimore: Johns Hopkins Press.
Institutd’Études Bancaires et FinanciÉres 1964 Les banques de développement dans le monde. Volume 1. Paris: Dunod.
International Finance Corporation 1964 Private Development Finance Companies. Washington: The Corporation.
Nyhart, J. D. 1964 Toward Professionalism in Development Banking. Unpublished manuscript, Massachusetts Institute of Technology.