Development banking and collateral-free lending

For a considerable period of time, various individuals have advocated the necessity of forming a State-owned development bank. The first development bank in Sri Lanka – the Development Finance Corporation of Ceylon (DFCC) was established in 1956. Thereafter, the National Development Bank (NDB) was established in 1978 to extend long-term credit to SMEs. 

The role of a Development Financing Institution (DFI) is to offer long-term capital to the corporate and SME sectors. In doing so, DFIs sometimes inject equity capital towards high-risk business ventures that produce financial returns over the long-term. DFCC during its time as a DFI was a premier financier of infrastructure-related projects in the country.

The notion of having a development bank has resurfaced in the public discourse with the NPP election manifesto expressing commitment towards establishing a development bank to meet the long-term and low-cost capital needs of industries. What is the value of the capital of this proposed development bank, how the funds would be raised, and when it would be established have not been divulged. 

It is doubtful whether the NPP economic policy council members have paid their attention towards the financing challenges associated with development banking. Prior to Sri Lanka becoming a middle-income state, the two development banks – DFCC and NDB – had the luxury of accessing long-term funding lines from multilateral financial institutes like the WB and ADB as well as bilateral agencies such as JICA at highly concessionary interest rates, enabling deployment of financial assistance to SMEs for long tenures at benign rates to ambitious entrepreneurs. However, when the island moved out from the status of a low-income country, the financial institutions could no longer tap such generous sources of financing. We all know what happened to Mahinda Rajapaksa’s Lankaputhra Development Bank and none of us would want to see a repetition of such a failed experiment. Setting up a development bank could be worthwhile but it needs to be done after an extensive analysis and forethought.

Meanwhile, the proposed development bank is also expected to provide collateral-free loans up to Rs. 10 million for start-ups and new business ideas purely based on the viability of feasibility studies. The NPP’s promise to offer loans without securities/guarantees has raised eyebrows among many. The supporters of this plan point out that collateral-less lending practices are possible and refer to the success of Bangladesh’s Grameen Bank to validate their argument. Nevertheless, such skewed opinions ignore that Grameen Bank is a microfinance institution which provides loans of small amounts without collaterals to groups of rural borrowers (mainly poor women) with peer pressure acting as a deterrent against default and therefore the comparisons are misleading.

Although people may not remember, an initiative of offering loans devoid of collaterals was implemented under the presidency of Chandrika Kumaratunga in 2005. The failed adventure was executed via an institution called the SME Bank and it came under the purview of the then Minister of Advanced Technology and Enterprise Development Rohitha Bogollagama. The State-owned bank was started with an initial capital of Rs. 5,000 million and its first branch was opened in Anuradhapura. The loans were offered at interest rates of 7% to 9% to entrepreneurs representing fields such as rice mills, gem cutting, ornamental fishing, garment, beauty culture, food processing and carpentry. Unfortunately, the extravagant scheme ended up in failure. The NPA (Non-Performing Assets) of the failed SME bank reached 35% of its loan portfolio with many loans having to be written off. Later, the unsuccessful venture was merged with the Lankaputhra Development Bank.

The suggestion of the NPP Presidential candidate to provide Government guarantee for loans disbursed without security is unwise and could cause additional burden for taxpayers. Culturally too Sri Lankans are known as wilful defaulters. Within such a social framework, attempting to lend advances without guarantees/securities solely on the assurance of taxpayers bearing the loss of possible/probable default would not gain the approval of people with financial literacy.