1. Towards financing development:an economic framework for development banking Janine Thorne 17 May 2007

2. Economic frameworkfor development banking • Literature on finance and development • Historical role of development finance • Principles for development banking • Case studies of development banks • Application to South Africa • Policy proposals

3. Scope • National development banks • Ownership: significant or full state ownership • Sources of funds: fiscal, concessionary and/or market funding • Application of funds: primarily wholesale • Four exclusions • Multilateral and regional development banks • Microfinance institutions • Deposit-taking development banks • Corporate issues, e.g. regulation, supervision and governance

4. Outline Towards an economic framework for development banking

5. Finance is key to development • Necessary but not sufficient condition for economic growth and development • Financial development both contributes to and is reinforced by economic growth and development

6. Borne out by economic theory… Financial development is critical; how to achieve it? • Keynesians: brain of economy; government must promote it • Neo-classicists: markets work best if left alone • New Keynesians: they don’t (transaction costs and asymmetries); government can improve outcomes • New institutionalists: neo-classical twist, role of institutions

7. Theory (cont.) • Emerging consensus view • Neither government nor market invariably best for financial development • Appropriate balance between market and government depends on specific conditions in each country

8. And by empirical evidence… The effect of finance on growth depends on: • Structure of financial system • Banks versus stock markets • Competitiveness of market (e.g. foreign banks) • Institutions • Legal systems that protect investor interests • Regulatory systems with market-based regulation • Government • Should not provide financial services • Should provide sound regulation and supervision

9. But financial systems in developing countries are weak… • Generally underdeveloped and often bank based • Credit rationed in favour of known and low-risk borrowers • Often invest mainly in government securities • Particular classes more affected: • Projects whose social benefits exceed their commercial ones • Long-term projects or projects with a long lead time • New or risky ventures, such as new technologies • Small and new borrowers without collateral or a track record

10. Thus need for development finance… Sources of development finance: • FDI: unpredictable and difficult to attract to poor countries • Donor funding: aid “tied”, insufficient, or for different objectives • Fiscus: governments lack sufficient resources for development • Markets: unwilling/unable to fund riskier sectors • DFIs: • Combine resources to fund riskier projects on commercial basis • Niche between fiscal and private funding • Lower risks of investment and crowd in the private sector

12. Role of DFIs • Financing role • Funding mobilisation for underserved segments, e.g. long-term lending, SMEs, microfinance lenders, sub-national government • Financial market and private sector development • Countercyclical lending • Special initiatives: regional integration, new technology, special funds, post-disaster reconstruction • Developmental role • Project identification and preparation • Capacity building and training • Monitoring and evaluation • Research and advice to clients and government • Coordination of funding sources

13. Development banks a popular option… • Large role in post-war reconstruction and industrialisation of old Europe and Japan • Provided term finance and investment knowledge • Not subject to public sector bureaucratic constraints • Operated on commercial principles • Developing countries set up development banks in 60s and 70s based on these successes

14. This did not always havethe desired outcome… • Many development banks failed • Government interference • Poor management and governance • Did not operate on commercial principles • Rigid and inappropriate mandates • Lack of integration into the financial system • Conflicting objectives: financial sustainability v. social outcomes • Large fiscal losses and poor developmental outcomes

15. However, development banks can work under specific circumstances: • Success of development banks depends on variety of factors • Absence of any one can lead to bank failure • Principles can be derived for the success of development banks

16. Principles for DFIs • Government • Risk of fiscal liabilities • Risk of non-delivery of development • How to ensure DFI efficient and effective? • DFI • Risk of (unprofitable) government directives • Risk of political interference • How best to manage conflicting objectives? • Balance accountability and autonomy

17. 1. Environment • Macroeconomic stability • Structural and microeconomic efficiency • Political stability • Supporting institutions

18. 2. Mandate and role • Mandate clarity • Local relevance • Institutional fit • Complementarity • Flexibility • Scope

19. 3.Governance • Ownership and control • Mainly government owned • Balance operational autonomy with oversight • Government conflict of interest: both owner and regulator • Corporate governance • Role and independence of Board • Accountability and capacity of management • Availability and retention of appropriate staff • Sound operational and risk management • Appropriate financial management

20. 4. Funding • De la Torre’s Sisyphus syndrome • Adequate capitalisation by government • Encourage approach to donors and capital markets (credit rating) • Fiscal support only to reimburse non-commercial activities done for state

21. 5. Evaluation • Clear performance contract • Agency problem – information asymmetry • Multidimensional outputs – some “invisible” but crucial • Incentivisation and target setting – yardstick competition? • Regular evaluation against agreed objectives • Assess financial and developmental objectives • Measures of outreach: worth, cost, depth, breadth, length, scope; social audit (likelihood of future impact) • Financial measures: standard financial ratios, subsidy dependence • Could this be achieved in other ways?

22. Summary • What environment do they need? • What is their role in it? • How are they controlled? • How are they run? • How are they funded? • Do they make a difference?

23. Do these principles work in practice? • Brazil: BNDES - similar to IDC and DBSA • Old Europe: KfW - evolution of DFI in mature system • India: IDBI - recently privatised: developmental functions? • Africa: viability of development banks in very underdeveloped financial systems

24. What does this mean for South Africa? • Developmental problems in South Africa? • What are we doing about it? • Is development finance helping? • Can we improve it? • Case study of the DBSA

25. What should we do differently? • Framework for development banking • Based on principles • Informed by lessons learnt from case studies • Proposals for improving the provision of development finance • Wider application beyond South Africa