Origin: Business and Banks
Date: March 14, 2008,
the city of Moscow

The establishment of Bank for Development and Foreign Economic Affairs on the basis of existing Vnesheconombank, which also incorporated OJSC Roseximbank and OJSC the Russian Development Bank should be seen as a new stage in developing the country’s financial and credit system. The Bank’s main objectives are declared to be: making the Russian Federation’s economy more competitive, encouraging investment activity, implementing projects both in Russia and abroad aimed at developing infrastructure, innovations, special economic zones, environment protection, supporting Russian industrial exports, works and services, small and medium-sized business.

To achieve the listed objectives of accelerating the development of Russia’s economy we need to try to find additional investment resources but this makes it necessary to somewhat change both the nature and organizational structure of the financial and credit system. The current system emerged in the 1990s, when the primary goal of reforming economic relations including financial and credit ones was to rapidly put them on a market-oriented footing. And it was assumed that competition would provide appropriate incentives to develop the economy and allow to step up redistribution processes.

But neither the dramatic increase in the number of commercial banks in the 1990s nor liberal conditions for their operation had any positive impact on the development of Russia’s economy and its real sector. We failed to concentrate financial resources and use them to develop high-priority industries. On the contrary, the Russian banking system’s operation contributed to increased export of capital and unjustifiable growth in government debt. This worsened the 1998 financial crisis dramatically.

The financial and credit policy was aimed at preventing any use of centralized financial resources to encourage the development of the real economy. The reason for it was that we ignored to study and apply foreign best practices in establishing development banks with the state participation, although these practices are widely used both by industrialized and developing countries.

About 750 development institutions, mostly banks, are estimated to be operating currently in the world. Development banks are highly instrumental in restructuring the economies even in such large countries as Germany, Japan, China, Italy, India and Brazil. This really means that it is not often quite productive to try to achieve optimal proportions in the economy by using market mechanisms alone. Development banks are particularly effective and useful in the situation of rebuilding, restructuring and modernizing the economy when we have to concentrate resources to achieve key objectives.

It is in this situation where our Russian economy is now. The accumulation of significant financial resources on the one hand, and the need to step up economic development on the other, make it necessary to make structural changes in the banking system as whole and establish development institutions in particular. Complexity and variety of objectives set for the Bank for Development in Russia necessitates addressing fully a whole range of issues ranging from identifying a list of its functions and objectives to laying down criteria for assessing its performance. A great deal of experience has been accumulated in the world in state development institutions’ functioning and it could be used efficiently in the Russian Bank for Development’s operation.

Development banks’ special position and role within the country’s single banking system are determined by such their distinguishing features as:

• specific mechanism for raising long-term resources;
• specific mechanism for long-term investing in fixed assets of the real sector (direct long-term and funded credits, investment in share capital, issuing and stock-market transactions);
• specific mechanism for short-term lending of real sector (in current assets and settlements) excluding outflow of credit resources into financial transactions, etc;
• system of institutional privileges designed to achieve the said objectives.

The fact that development banks are quite common accounts for the diversity of their organizational structures and functions. In world practice a category of development banks includes investment institutions engaged in long-term lending (mostly on preferential terms) of certain industries and sectors. As opposed to commercial banks, these institutions do not accept deposits from depositors; they also do not conduct settlement and payment transactions and do not tend to extend short-term loans. Despite the differences in their organizational schemes and functions state development institutions in both developing and industrialized countries are, above all, designed to alleviate financial problems faced by companies and industries which have limited access to commercial banks’ financial resources on standard market terms.

As a whole, we can single out two principal patterns of their operation. In industrialized countries with mature money markets and fairly diversified credit and banking systems state financial institutions from the outset gave top priority to creating conditions for ensuring equal opportunities for access to commercial credits by economic entities. In this respect their main function was to extend additional guarantees for high-risk commercial credits as well as provide subsidies to borrowers with limited solvency (small and medium-sized business).

In developing countries development banks were tasked with wider functions. In most countries they factually played one of the most important role in the government’s policy of rebuilding and developing basic industries, agriculture and production infrastructure. In developing countries’ financial strategies state development institutions’ role has somewhat diminished (among other things due to increased potential and better performance of commercial banks). But in most cases they are still instrumental in addressing both national economic and social problems.

Development banks’ main lines of activity include:

• accumulating financial resources from foreign and domestic sources to implement government investment policy;
• expert’s examination of projects to be carried out by using funds from the development budgets and other sources;
• targeted financing and lending of highly efficient investment projects in the real sector of the economy including manufacturing and export of high-technology products;
• lending of companies operating in the real sector of the economy which are temporarily pressed for current assets and offering them payment and cash services;
• providing support for investment and other projects in the real sector of the economy by way of extending guarantees for raised credits granted by foreign and Russian financial institutions;
• placing industrial government bonds and opening deposits guaranteed by the state to raise people’s money for investment purposes;
• consulting companies on the issues of their restructuring and development, raising credit resources, issuing shares and bonds.

Development banks’ functions can be performed by various credit and banking institutions: financial corporations, industrial banks, industrial and multi-industrial corporations, banks and funds of industrial and agricultural development, special credit institutions involved in financing small and medium-sized businessmen etc.

Experience of the post-war Japan, South Korea as well s of economic market development in developing and East European countries demonstrates that selective government’s credit policy carried out by development banks, given effective refinancing and control mechanisms, is a crucial factor in rebuilding economy and encouraging economic growth. In Japan, increased share of credits extended to industrial companies by state and quasi-state financial institutions in the post-war recovery and reconstruction period contributed to a certain extent to high economic growth rates of Japan’s economy. Preferential credits extended by these institutions accounted for more than a half of all long-term credits, with their share being particularly high in top-priority but capital-intensive mining, chemical, smelting and transport machine building sectors.

And nowadays, development institutions are of considerable importance. For example, the Japan Development Bank, founded in 1999, focuses its activity on preferential lending of industries (as a rule for a period of less than one year) and on extending credits which private banks are reluctant to offer. The Bank is also plays an important part in implementing large-scale foreign projects.

The Bank gives practical recommendations with regard to projects and provides access to resources through private financing initiatives, project financing as well as other financing methods. As a bank of expertise, it is capable of combining financing services with complementing consulting and organizational services. The bank’s main lines of activity include supporting regional and urban centers, modernizing transport infrastructure, developing state-of-the-art information technologies and communications systems. The Bank’s top priorities include initiatives on protecting environment (developing power engineering with the use of natural factors such as wind, tides etc.). The Japan Development Bank’s predecessors also paid regard to both national and regional aspects but for them it was an exception rather than a rule.

Moreover, state corporations play a significant part in Japan’s economy. Through them, Japan’s government carries out government programs of supporting and developing the Japanese economy. There are four state corporations operating in Japan. They include the Housing Lending Corporation, the Corporation for Financing Agriculture, Forestry and Fishery, the Japan Finance Corporation for Small Business, the Japan Small and Medium-Sized Businesses Corporation as well as the Association for Credit Guarantees.

Preferential interest rates were used extensively in East European countries from the early 1990s for the production sector, above all, to restructure companies and develop export-oriented production facilities. For example, in Hungary targeted long-term credits for refinancing were extended in the amount of up to 50% of expenses earmarked for spending.

State development institutions were also of crucial importance for modernizing developing countries’ economies.

And although drastic reduction in budgetary subsidies and preferential credits granted by central banks and transition to mostly market-oriented mechanisms for forming funds in the last decade reduced preferential terms for credits, as a whole, state development institutions do not use market criteria and principles as often as commercial banks.

Preferential terms of lending top-priority industries are possible due to longer repayment periods for credits, less stringent requirements for guarantees, an easier procedure for rescheduling credits extended earlier in case of the borrower’s temporary problems, combining preferential credits with credits on market terms etc. For example, development banks’ credits in many Latin American countries are extended for a period of up to 20 years with a three-year grace period depending on the nature of project. In case of socially meaningful projects, interest rates can be set on a preferential basis.

There is still a trend towards extending medium and long-term credits. In the late 1990s, long-term credits accounted for 38% of all assets of 53 largest Latin American development banks (short-term credits accounted for 12%). High priority was given to lending agriculture and agro-industrial complex (21%), manufacturing industry (13%), education, public healthcare and other basic services (8%), foreign trade (6%).

Studying development banks’ activities in different countries allows us to come to certain reasonable conclusions that can be taken into account if we are to carry out a similar modernization of Russia’s financial and credit system.

In particular, there is a direct link between the number of objectives faced by development institutions (banks) and the number of such banks. A long list of various investment spheres stated in the Law ”On Bank for Development” allows us to arrive at the conclusion that it would be difficult for one bank to perform all these functions. It is evident that investment activity efficiency in various areas is different. Moreover, concentration of resources in one bank might deprive some lines of investment activity of required fund sources. That is why in our opinion it would be useful to use foreign best practices to establish a number of specialized banks (or finance corporations) responsible for appropriate financing to address high-priority objectives of economic development.

In many countries where development banks operate they found it expedient to establish a network of banks specializing in supporting a specific industry or sector. This sort of development banks system is standard practice in Mexico, Brazil, Chile and a number of other countries. The largest German development bank KfW is a holding incorporating five specialized banks.

Given the globalization of economy and the opening of foreign markets, development banks are increasingly focusing on developing export sector. From lending foreign trade transactions they switched over to a more diversified policy aimed at making export-oriented industries and companies more competitive and are involved not only in direct lending of foreign trade transactions but also in lending production processes at various stages of manufacturing export products including credits for replenishing current assets. Their main goal is to make national products more competitive in foreign markets.

In addition to financing exports including manufacturing of export products and their sale in foreign markets, development banks grant guarantees for credits extended by commercial institutions to small businesses involved in manufacturing export products.

Specialized foreign trade banks’ activities are no less important with respect to such lines of activity as studying and submitting information about conditions on foreign markets with singling out specific requirements to be complied with in one or another country, financing costs for staging exhibitions and fairs and refresher training programs for representatives of small and medium-sized business.

In the past years development banks have been stepping up their efforts to:

• optimize current financing schemes and mechanisms designed to speed up the development of industries and regions, including small business;
• upgrade the system of examining and working out new projects of national significance;
• strengthen ties with commercial banks in credit and payment relations, increase commercial banks’ share in development institutions’ financial programs;
• develop non-bank financial institutions, manage and control commercial risks;
• develop the domestic securities market and help small and medium-sized businesses to enter the domestic money market;
• increase the share of credits extended for technological modernization, finance refresher training programs for companies’ managerial personnel, streamline management systems and systems of boosting labor productivity particularly at small and medium-sized businesses.

One of the principal issues of establishing development banks (institutions) and their operation is associated with the state’s participation in organizing and managing these banks. The Russian financial authorities are particularly sensitive to this issue. Negative attitude to the state’s increased role in the country’s economic life hinders to ensure an appropriate combination of the state’s and private interests and efficient operation of the banking system and corporations. It is quite revealing that despite the fact that development banks’ functions and main lines of activity have changed considerably in the last years abroad they are still controlled by the state. Currently, in 8 of 10 functioning development banks the state’ share in the capital remains full and predominant and this does not hinder but helps to achieve optimal results in financial and economic activity, particularly in the countries with transition economy.

The state’s participation does not mean that commercial banks should not be involved in financing and lending sectors identified by the government. Cooperation with development banks creates favorable conditions for commercial banks to raise additional resources and not only government ones but private ones too. As practice shows, authorized commercial banks are more trusted than other banks.

Moreover, such authorized banks tend to increase their marketing level by offering various expert and consulting services to select the most efficient financing objects.

Foreign experience testifies to the fact that state development banks’ institutional structure is quite flexible and that they can be easily restructured and adapt to economic conditions and increase the amount of raised private resources.

In addition to budgetary funds and loans raised in securities markets development banks can mobilize long-term capitals by using a part of commercial banks’ reserves. In order to do this:

• the central bank can place a part of commercial banks’ mandatory reserves in development banks bonds with fixed interest payment;
• the central bank can raise a part of commercial banks’ mandatory reserves through development banks’ bonds;
• a part of commercial banks’ voluntary reserves can be placed in development banks’ bonds, this necessitates government guarantees for these bonds, tax credits for yields from them, and the possibility for the state to pay (fully or partially) interest on these bonds.

As is the case in world practice, population savings could be a potential source of financial resources for development banks in Russia. In addition to raising individual savings through the Bank for Development’s bond issue for population as well as through Russia’s Savings Bank (Sberbank) we should keep in mind that pension funds’ resources could also be used for this purpose.

In Japan, for example, proceeds from a special account with the Finance Ministry’s Trust Fund Bureau responsible for operating state pension and insurance institutions, account for up to 70 % of the Japan Development Bank’s total amount of resources.

Until recently, Sweden’s pension fund accounted for about 40% of credit resources supply on this country’s financial market.

Diversification of project financing sources makes it possible to reduce risks upon lending low-profit projects and to boost development banks’ performance.

The Russian Bank for Development’s activity along with applying underlying principles of foreign development banks’ operation should be based on the distinguishing features of the Russian economy where a search for ways to promote cooperation between the real sector and the Russian banking system to encourage innovative economic development is still urgent.

Above all, development institutions’ role in financing various industries and projects, which are not attractive to private business, is becoming increasingly important in Russia. Despite the fact that the situation in the banking sector has improved, given the positive dynamics of Russian commercial banks’ performance indicators, these banks fail to properly perform the functions of transforming raised funds into investments. In general, banks are still specializing in redistributing funds between businesses (mostly, in the non-productive sector).

Despite large absolute volume of credits extended to non-financial organizations (8.1 trillion rubles as of 01.10.2007) their share in the banking sector’s assets hasn’t in fact increased (in 2006 it was 43.8% and as of 01.10.2007 – 44.4%). The bulk of credits is concentrating in export-oriented sectors and capital outflow from raw materials sectors into manufacturing industries is held back by low (lower than refinancing rate) profitability in these industries.

According to the Bank of Russia’s annual report for 2006, the number of banks with the capital adequacy indicator of less than 12% increased by 1.7 times. On the other hand, for only 9 months of 2007, the banking sector’s aggregate amount of risks to be considered upon calculating equity adequacy ratio increased by 37.4%, with the share of credit risk accounting for 95.3%. And an increase in overdue indebtedness on credits, deposits and other invested funds (46.2) was higher than the lending volume (36.8%).

The proportion of the banking sector’s long-term liabilities is still low in the total amount of liabilities. Although the share of deposits had increased significantly (to 46%) by early 2007, with these deposits being raised for a period from one to three years, the proportion of deposits for a period of more than three years was only 6.3%, and this is insufficient for long-term lending.

The foreign capital presence has further expanded on the market for banking services. For example, by early 2007 the number of banks controlled by non-residents was 65, and by September of 2007 it grew to 83, with 18 of them being among the 50 largest Russian banks by the amount of assets. We can hardly expect foreign capital to actively participate in the modernization of the Russian economy.

On the other hand, on the background of significant difference between interest rates levels in Russia and on international financial markets, there is a clear growth trend in the loans raised by Russian institutions abroad. According to the Bank of Russia’s data, banks’ debt to non-residents amounted to 147.7 billion dollars by September of 2007 and it increased by 45.9% from the start of the year whereas other economic sectors’ debt was 230.4 billion dollars. The increased amount of foreign capital in the situation of lower labor productivity (stated in the latest reports by the Ministry of Economic Development and Trade) influences price growth rather than economic growth and can hardly be seen as a reliable source of addressing economic structural problems. Under these conditions, the establishment of development banks with state capital might be aimed at a more active participation by the state in pursuing structural economic policy by way of investing on a large scale in top-priority industries.

Development banks’ role will be determined not only by significant volumes of investments (by experts’ estimates they might reach 3 trillion rubles and account for a fourth of all debt obligations by institutions and population to commercial banks as of September 1, 2007) but also by their participation in operating in strategically important economic sector under the state’s control (aviation, cosmonautics, nanotechnologies information technologies etc) thus helping to progressively restructure our national economy. Given significant depreciation of fixed assets in almost all industries (in smelting industry –50%, mechanical engineering –45%, light industry –54%) and drastic decline in high technology production facilities manufacturing deeply processed products, we should put other industries, above all, mechanical engineering (as well as agriculture) and machine tool building on this list of strategic priorities.

Equipment, machinery and instruments can be in demand in agriculture, public healthcare, light and food industries (national projects also aim to address problems in these sectors). But in order to manufacture them we need modern machine tools and technologies in high demand at the present time when Russia moved from 3d place in the world in terms of manufacturing and 2^nd place in terms of consuming machine building products in 1990 to 22^nd and 19^th place and its share in the high technology segment shrank to 0.5%.

Investments in mechanical building industry is capable of having a far significant impact on aggregate and interim consumer demand and increase multiplier effect caused by increased output, employment and incomes in a specific industry depending on labor and material intensity in a given industry. The higher labor and material intensity and the wage share in value added, the greater this impact will be. With due regard to the fact that this share varies a lot in different industries (from 4% in the gas industry to 80% in the mechanical engineering) and the bulk of investments go to mineral-extracting industries, it is quite evident that investment multiplier remains to be at a low level.

The current Russian import structure has a negative impact on this process, the proportion of machinery and equipment in Russia’s import was 54% in January-November of 2007 (in 2006 –51.3%) and the consumer demand generated by investments was met, to a large extent, by the import of consumer goods. As the share of import in the Russian economy has been 43-44% in the past years in the total amount of household final consumption, investment multiplier effect is declining dramatically.

In order to technologically develop and improve machine building production facilities there is a need for the state’s participation in creating adequate integrated structures (research integrated with production), programs of personnel training and rotation as well as reducing transaction costs and expenses in financial sectors by making credits cheaper. In this respect, the Bank for Development’s financial assistance to the new state corporation Rostechnologies is of great importance

We find it expedient to concentrate funds and efforts on implementing a national project aimed at developing the agrarian sector by way of:

• extending credits to agricultural machine-building businesses for further sale of their products to agricultural producers under leasing schemes;
• rendering credit assistance by Rosselkhozbank to agricultural businesses upon purchasing machinery manufactured with the help of funds from the Bank for Development under leasing schemes.

This sort of scheme would allow to set into motion a whole chain of technological ties to ensure Russia’s food security and a rapid growth in foodstuffs imports is a threat to it, for example, according Russian Statistics Committee’s data, meat imports from far abroad increased by8.9% in January – November of 2007 (from CIS countries – by 33% (50%), fish imports – by 26.3% (9.7%), sugar imports – by 38.9% (54.1%) respectively).

To maximally reduce potential negative impact of selective credit policy on bringing about financial stabilization we should limit both the number of top priority industries or programs and a temporary period of their financial support and establish well-defined legal procedures for ensuring timely loan repayment.

State development institutions’ best practices demonstrate that the need for such institutions (banks) is particularly great in capital-intensive industries, which are not attractive to normal commercial banks although their development is crucially important for national economies.

Development banks made it possible to technologically retool a number of Japanese industries, above all, power engineering, automotive and fishery industries. These banks were instrumental in creating new industries in Latin America as well as in stepping up the development of backward regions in such countries as Brazil, Mexico, Japan and others.

A choice of priorities for foreign development banks does not depend only on a specific industry’s importance or a purpose of expenses but also on a development level of private financial institutions. In order to prevent undesirable and unequal competition between state development banks and private financial institutions, preference is to be given to private financial institutions as this sort of competition can suppress private financial sector and give rise to financial tensions in the economy. The more private financial institutions are developed, diversified and stable in a country, the less a need for the state’s participation. That is why, development banks’ scope of activity has been diminishing in industrialized and some developing countries in the recent years.

Development banks’ performance efficiency, to a large extent, depends on the optimal formation of their resource base and combination of its various sources. Development banks’ cooperation with commercial banks makes it possible to not only extend additional credit resources to authorized commercial banks but also to use their own resources for lending in accordance with their plans. Moreover, development banks can purchase resources through conducting transactions on financial markets. According to foreign reports, this source of resources is gathering momentum. There should be different modes of using these resources because their economic nature is different.

In foreign business literature it is common to divide development banks depending on the procedure for forming resources into:

• “first-level” banks, which have the right to use all means of raising funds,
• “second-level” banks whose resources can be formed by using budgetary funds, extrabudgetary funds, foreign institutions’ loans and issuing their own debt obligations.

In the recent years preference has been given to second –level banks, which do not compete against commercial banks.

In Russia, the evolution of development banks might result in using both the first and the second version of forming resources.

Development banks’ weak organizational structure necessitates their close cooperation with commercial banks.  At present there is a need for the second version of forming resources in Russia. The need for searching out financial funds for the development of the Russian economy is not in line with the Russian financial authorities’ action on placing financial resources into foreign assets.  A tendency to channel financial resources abroad is not a sign of any willingness to protect but rather a sign of inability to use them effectively. By the way, it is a full responsibility of financial authorities themselves to use these resources through development banks.

It might make sense to divide investment project financing funds, as is the case with Latin American multilateral development banks, into:

• special transactions fund formed from budgetary funds and fairly cheap raised funds (including funds from the National Welfare Fund and the Reserve Fund as well as pension savings) resource from this fund can be used to finance low-profit and long-term projects in the industries of the real sector of the economy;
• main resources fund replenished by raising funds in financial markets and used to finance fairly high-profit projects with a short payback period (for example, construction of toll motorways within public private partnership schemes). This division of financing sources would allow us to significantly reduce interest rate risks when addressing national objectives but also can require introducing appropriate changes into a new bank’s organizational structure.

At the same time, we should not forget that budget investment efficiency might be expressed in indirect indicators and after a rather long period of time. For example, development of transport, information and institutional infrastructure would help to boost business activity both in allied industries and businesses using appropriate infrastructure facilities to develop production and this would eventually increase tax base and budget revenues.

Development banks are crucially important because as they expand their capital base and increase the number of transactions they would have a positive influence on the banking system as a whole by using a mechanism of two-tier financing and this can involve commercial partner banks in funding the real sector thus boosting their resource and increasing their profitability.

At the same time, main criteria for selecting agent banks of the state corporation should be agreed upon: these agent banks might be required to disclose their principal beneficiaries to determine responsibility for an agent bank’s activity, credit institutions are not to be allowed to be the Bank’s agents if their resource base depends heavily on the market for interbank credits and if they have loan portfolio arrears of more than 1%, the number of potential agent banks should be limited if the amount of their equity is lower that the established rate for example, 100 million dollars) in the case that they are determined to participate in funding a major infrastructure project. At the same time these limitations should not be applicable to agent banks participating in the Bank for Development’s program of financing small and medium-sized business.

The state’s efforts to involve commercial banks in financing socially meaningful projects should be made with using a range of such market instruments as: the state’ guarantees granted to institutions responsible for providing banks with credit resources, free or preferential guarantees extended by the state to development banks to insure them against defaulted loans, free or preferential extension of the state’ funds as sources of financing specific investment objects. Globalization processes, intensified integration tendencies in economies of both industrialized and developing countries influence development banks’ nature and functions. Recently, the largest development banks including those in developing countries have been expanding the network of their branches and representative offices abroad. In this way, they are increasingly raising investment resources for their countries’ markets and help their companies to enter foreign markets.

Specialized export-import banks are also advancing rapidly. Nowadays, there are about 70 institutions of this kind in the world. Such bank can be both state-run and private acting under the patronage of the state or associations of national companies. They are most active in developing countries particularly in supporting small business. These banks do not only finance exporters directly but they also provide assistance to export-oriented production along the whole production chain.

By their nature, export-import banks are close to various international banks. Such institutions are particularly important for establishing production ties on the territory of the former Soviet Union. The Soviet republics’ political disintegration broke up production ties between many businesses in various industries. The establishment of development banks (including international banks as well) would help to restore these ties, give impetus to integration processes and have a positive impact on these countries’ economies.