Lend aggressively but responsibly

Developing countries today target high growth through investments in infrastructure, modernisation and expansion of manufacturing and service facilities, and in agriculture and allied areas. At the same time, they seek to enable disadvantaged sections upgrade their standard of living. In this, the developing countries expect financial institutions to act aggressively as well as responsibly.

The global financial structure, as it is evolving, is a technological marvel. Assets originating at the base are securitised, packaged and repackaged in different forms for sale to investors all across the globe. These assets, if infected with a high probability of default, will always carry the germs of a systemic crisis. The lending agencies therefore have an enormous responsibility; while a high growth economy offers opportunities for profits, lenders need to be (despite insistent pressures from powerful borrowers and politicians) extremely cautious and desist from taking on high risk assets.

A good example in this regard is the subprime mortgage market crisis in the USA during the decade just gone by. The lending ambience was congenial: a continually rising property market, a flood of liquidity fed by an upsurge in global savings and an accommodating credit policy. The lenders had two options: low profit, low risk from sound but relatively few mortgage assets, and high profit, high risk from high risk but abundant mortgage assets.

Lending agencies chose the second option—a choice dictated by the inexorable logic of a profit-driven market economy. They lured subprime borrowers with a slew of ‘innovations’ to create assets at any cost: progressively relaxing margin money, dispensing with the requirement of income investigation, dismissing borrower concerns about unexpected shortfalls in their disposable incomes, and holding out the assurance that rising property prices provided enough leeway for borrowers to meet repayment obligations through the sale of houses. All this they did, not out of any philanthropic zeal but out of the urge (given the opportunity) to make quick profits. The major premise underlying their behaviour was that if the property market collapsed leading to a systemic crisis, the state could not but step in, as it had indeed done several times in the past.

State intervention in a crisis is a must, but the challenge before any polity is to intervene before the crisis erupts and to do so in a manner that helps the lending agencies generate a sustainable level of good assets. Such intervention must be planned and designed such that a balance is struck between the aspiration of marginal borrowers (to create and own assets) and the continued viability of lending agencies—critical for the efficiency and stability of any financial system. If we are to grapple with the recurring problem of non-performing assets and continue uninterruptedly with pushing social sector lending and infrastructure development, the polity has to act innovatively: there has to be a partnership, so to speak, between the state and the financial system.

But what kind of a partnership?  Two points need to be made here. The plea for state participation is not to seek a return to the ‘loan mela’ days of political patronage, to open the purse strings for subsidies, to displace private ownership, to interfere with the individual credit decisions of lending agencies, or to justify the oft-talked about practice of lending at political behest. This is a plea for selective public  investment aimed at enhancing the viability of private sector projects and the income and employment potentials for the disadvantaged sectors.

Take housing for instance. Our desire to have a pool of affordable houses has hardly made any headway primarily because of the prohibitive cost of land. The State has to do some out-of-the-box thinking to clear the hurdles in the availability of land at a reasonable price; this will make a significant impact on the pool of affordable houses. The flow of funds from the State and the lending agencies, made available in tandem and planned and targeted at select locations and sectors, should be the basis for this partnership.

A second point. Admittedly, we have to push private-sector investments into different types of infrastructure, industry and agriculture for sustaining growth and generating employment. In this regard, a good many projects are clearly viable and remain good candidates for institutional funding, even as several others continue to inhabit the penumbra zone. Given the technological complexities and demand in today’s dynamic global economy, and with the kind of in-house skills currently available, the projects of the latter variety do not lend themselves to easy appraisal. It is also next to impossible for individual lending agencies to cost-effectively build in-house skills for the accurate evaluation of these projects. If investments in all key sectors are to be pushed aggressively, we must have special institutions with the mandate to assess these projects and to provide such critical financial assistance as can induce the lending institutions to lend appropriately to them.

We had set up development finance institutions in the early stages of our industrialisation in the fifties and early sixties; nearly 75 per cent of the cumulate private investment was canalised through these. However, we committed the grievous mistake of scrapping these institutions in the nineties. On the other hand, China, years after it had switched over to a market economy, set up its National Development Bank in 1995; the institution is estimated to have financed over 60 per cent of the total private investment in that country since then. Brazil is another illustrious example in this regard, while even Germany and Japan are continuing with these types of development banks. Back home, in India, we must recognise that, without the critical support, financial and otherwise, that such national level development finance institutions can provide, our objective of creating a sustainable level of good assets and maintaining a steady rate of growth is bound to remain hamstrung.

 (The writer is former Secretary, Government of India, and former Chairman of the State Bank of India)