Establishing development banks

Governments in developing countries have established development banks which are in most cases funded from government budgets and contributions from external bilateral and multilateral donors. Development banks provide long-term finance for investment in selected sectors and they play a useful role in promoting industrial development. The creation of these banks purports to combine developmental objectives with sound banking practices. Many such institutions have also special "windows" to provide long-term finance to SMEs, albeit on a limited basis.

The Development Bank of Mauritius has implemented a successful SME lending programme, by operating a network of one-man regional offices able to respond quickly to SME needs and to monitor effectively the borrower's performance. The Industrial Development Bank of India helped to set up state financial corporations and acted as an apex institution to channel funds to these corporations, particularly for lending to SMEs.

Some development banks also provide refinancing facilities whereby loans extended by commercial banks to SMEs are rediscounted by a fund created for this purpose in apex institutions. Refinancing has the added advantage of helping commercial banks to build up their capacity to appraise SME loans.

Apart from their financial problems and limited resources, other characteristics of development banks have constrained their dealings with SMEs. Usually very centralized, they lack the branch network that is needed to respond quickly to the demands of SMEs. They usually do not lend working capital, which is often the primary financial need of SMEs. The documentation and paperwork required to obtain a loan result in the slow processing of loan requests and represent an obstacle for SMEs to approach these banks. The setting up by development banks of independent subsidiary units to deal with SMEs might help to overcome some of the problems by obtaining special low-cost funds from the government and from foreign donors, and by special staffing to monitor loans and to offer ancillary services (such as advisory services, training programmes, marketing services).

Although experiences of development banks in developing countries in providing term finance to SMEs have met with mixed results, in many countries there is no alternative for governments and foreign donors than to use development banks as the major conduit for financing SMEs. Where the commercial banks are unwilling or unable to become involved in lending to SMEs, as in many African countries, development banks remain the major source of finance, apart from non-banks sources. Development banks are also more willing to finance new enterprises or riskier but viable projects than commercial banks which, because of their conservative practice, are reluctant to approve such loans. Development banks are also perhaps more willing to invest in staff trained to help small business to prepare their projects for loan requests.

Support for development objectives can be at the expense of portfolio quality. This results in financial frailty such as when the world economy entered a recession in the early 1980s. For a sample of development banks at the end of 1983, almost half had 25% of their loans in arrears and almost a quarter had more than 50% in arrears. Some have since been bailed out by the government or the central bank, but many remain under heavy financial pressure, and some under threat of insolvency. Some development banks perform badly because their managements are forced to finance unviable government projects. In addition, interest rate controls together with excessively high interest rate margins inhibit development banks from mobilizing deposits. As a result, most of these institutions remain small and narrowly focused and depend on official or semiofficial sources for funding.