Discussing the merits of a development bank

By Luca Sacco

According to official reports development banks are government-sponsored financial institutions concerned primarily with the provision of long-term capital to industry.

This definition highlights two key aspects of development banks: their state-owned status, and their emphasis on solving gaps in credit markets, especially in the case of projects with long-term maturity. Perhaps in the past development banks were widely associated with rigid Communist regimes that propose their wish to extend control over bank lending to major projects.

However, following the 2007/8 recession we meet defendants of state banking who see development banks as an important tool to solve market failure leading to suboptimal productive investment. Thus, development banks can help solve market imperfections that would leave either profitable projects or projects that generate positive externalities without adequate financing due to their risk profile. 

Moreover, in economies with significant capital constraints, development banks

can alleviate capital scarcity and promote entrepreneurial action to boost new or existing industries as they do more than just lending to build large infrastructural projects or typically invest in the long term land reclamation sector.

They also lend to companies that would not undertake projects if it were not for the availability of long-term, subsidised funding of a development bank. Naturally this does not mean that, while retail banks are now under a new barrage of regulation from the ECB, the use of a development bank will be like using a blank cheque, but the risk appetite of a development bank is better suited for provision of credit to firms with capital made conditional on operational improvements and performance targets.

In such circumstances, we would expect to see such firms which borrow from development banks increasing capital investments and overall profitability after they get the necessary financing. Of course there is a negative attitude towards the existence of development banks since some argue these are created to suit political ambitions of leaders via state-owned banks to bail out companies that would otherwise fail or to maximise their personal objectives or engage in patronage deals with politically-connected industrialists.

Some examples of where development banks are used include Germany, Croatia, Turkey and Russia among others. To start with the Russian development bank, better known as Vnesheconombank, this is considered to be one of the key instruments for implementing the state economic policy aimed at removing infrastructural restrictions that impede economic growth.

The bank helps in enhancing efficient utilisation of natural resources, unleashing innovative and industrial potential of SMEs, ensuring support for the exports of industrial goods and services as well as protecting the environment.

When it comes to investment activities, the bank mainly focuses on the aircraft industry, shipbuilding, transport and economics industry among others.

Another good example is the Industrial Development Bank of Turkey, known as TSKB, which plays a significant role in extending medium to long-term credit for investments and project financing with particular focus on the environmental as well as the renewable energy sector.

It finances enterprises directly by taking the risk of the company as well as indirectly through leasing companies and commercial banks. Investment banking is offered through the TSKB along with capital market intermediary and portfolio management services.

The bank is active in public offerings of shares of companies, privatisation consultancy and acquisition advisory services.

KfW Bankengruppe is the main development bank in Germany,  which takes particular responsibility for promoting the protection of the environment and climate. In fact, around one third of the financing volume is dedicated solely to this sector but apart from providing programmes and incentives to the environment sector, the bank also puts emphasis on the housing sector, asset securitisation and promotion of SMEs.

Finally one can introduce the Croatian Bank for Reconstruction and Development (HBOR). It plays the pivotal role of an export and development bank within the Croatian banking system.

Its main objective is that of financing the reconstruction and development of the Croatian economy. This is mainly accomplished by promoting exports and insuring the exports of Croatian goods and services against non-marketable risks, financing infrastructures, supporting the development of small- and medium-sized enterprises and promoting environmental protection.

The bank supports small and medium-sized entrepreneurship, infrastructural projects, tourism, industry, agriculture, environmental protection and export (pre- and post-shipment export finance, supplier/buyer credit, credit lines) with the intention of balancing the regional development of Croatia.

HBOR also gives loans for incentives to SME start-ups and loans to improve liquidity as well as loans for innovations and new technology projects. As an export credit insurer, HBOR provides state-backed pre- and post-shipment cover of non-marketable risks against commercial and political risks for export transactions to companies, commercial banks and other financial institutions as well as outward investment insurance.

Back home, the question whether Malta should establish a development bank or not has recently been on the agenda of various experts in the field of finance. Malta is not privileged to start reaping the benefits of such an institution, in fact according to the Central Bank Governor, Malta needs a development bank in order to fill national financial gaps that commercial banks are not bridging.

Indeed, commercial banks have risk appetite for handling liabilities that are considered to be small and are of short maturity as well as essentially liquid. However, the credit required for most public and infrastructural projects tends to be individually large, subject to income and capital risk and substantially illiquid in nature.

Consequently, commercial banks limit themselves in accordance with Basel 111 rules and thus focus on providing working capital credit to industry. This is done against the collateral constituted by firms’ inventories of raw materials, final products and work-in-progress and its projected viability.

This retail type of banking in Malta has over the years succeeded to provide credit in relatively large volumes, with significant income and credit risk as well as a degree of illiquidity. However, this will yield a lower degree of maturity and liquidity mismatch.

In fact, in practice large projects are going to the capital markets by way of issuing unsecured bonds as there otherwise they find difficulties due to the fact that commercial banks have constraints when it comes to large loans. This credit tightness makes traditional commercial banks less suited to lending for long term capital investment. In light of this, development banks cater for this shortfall in funds required for long-term investment by providing long-term financing for public projects and extending credit to sectors starved for liquidity.

What is important to highlight is the fact that development banks are intended to complement activities of commercial banks rather than compete with them.  Globally we see how development banks helped in mitigating the effect of the 2008 crisis, which adversely affected various economies around the world and forced non-EU countries to undergo internal currency devaluations.

In fact, financial experts claim that Malta has been lucky to ride the storm during the crisis and this is commendable and may be partly due to a conservative lending policy, and of course the excess liquidity offered a safe haven.

Now that the EU financial crisis is on its way out Malta can still revisit the subject of having its own development institution as a long term source of finance. Development banks are considered to be the main drivers of the industrial sector, as they provide financial, technical as well as administrative assistance to the sector.

As stated earlier they are absent in Malta but once set in motion they can add to existing competition for credit by promoting new avenues for savings and investments in the public domain, undertake successfully a role in promoting the economy and help in assisting the government in social and environment projects.

This in turn will lead to important infrastructural private sector development and naturally secure sustainable jobs.

While discussing development banks one cannot omit to refer to the current hot topic started by a declaration by the Governor of the Central Bank, who officially stated that lower lending may be due to the higher cost of interest charged in Malta.

In this context PKF is currently talking to a number of stakeholders to collect empirical data from banks and other institutions to analyse the cost of borrowing linked to evaluation of risks within the SME sector ( ie loans under €1,000,000).

While deposit rates offered by Maltese banks are approximately in line with those across the euro area, interest rates on loans to businesses are currently higher than those offered by other European countries, even though the rates set by the ECB for Malta are lower.

In light of this, the perception lingers that bank interest margins in Malta are considered to be high, and the possible setting up of a development bank would certainly help in filling the funding gap that currently exists in the Maltese financial sector and in creating important dynamics to fund big projects.

In conclusion, it would ease the difficulty faced by larger companies as well as SMEs when it comes to sourcing funds and access to finance as well as providing relief to the costs incurred, especially to enterprises in the tourism sector.

Luca Sacco is a trainee statistician with PKF Malta