DF201|Question 4

What are the inherent contradictions in the role of development banks and how may these difficulties be overcome?

Inherent difficulties of Development Banks fall into two categories:
1. Their scope as Financial Institutions.
2. Development Banks' role as an arm of government policy.

1. Difficulties as Financial Institutions
1. Problems of specialization that can concentrate risk and non-diversification of portfolios.
2. By the very nature that development banks are designed to fill a highly risky endeavors but still maintain the profit motive of a normal bank. It can always be easier if it was just handing out money.
3. "The low funding costs also open up the possibility of private rent-seeking by individuals in a position to affect credit allocation."
4. In the case of small agricultural borrowers and small business, monitoring costs ate prohibitive and in some cases repayment proportions may be very low. There are no economies of scale in monitoring borrowers, in this situation. If the development bank operates as a revolving fund, where repaid loans are then lent out again, and repayment rates are low, the bank can find itself short of liquidity as a result.

Difficulties with Government Policy Criteria
A man that serves two masters serves neither...
Development objectives:
employment creation, foreign exchange earning, income distribution, diversification of industry, modernization of agriculture, development of small business, encouragement of entrepreneurship, development of the capital market...

2.2.1 Benefits and Costs of Specialization
There is an economic advantage to this (specialization) in one sense; namely, that there are cost economies in getting to know one sector and its borrowers in detail. This may or may not offset the greater risk from specialization.
2.2.2 Allocation by Social versus Economic Criteria
...credit allocated by criteria such as those listed above, is not necessarily allocated to the technicaly most efficient or most profitable enterprises.
2.2.3 Development Banks and Capital Market Development
...development banks may become rather passive channels of cheap funds rather than acting as an active financial intermediary between national savers and borrowers.

Overcome Difficulties
Creation of a "Post Office Savings system" thus reducing one of the "Two Gaps" internally.

Dynamic Comparative Advantage
If investment is being made in increasing a country's capital stock relative to its labor force, or in introducing new technologies, arguably it is the future pattern of comparative advantage that is relevant and not the current one.

Community Banks-Policed by Members
Credit Associations or Credit Co-operatives. Mujin in Japanese (mutual financing associations).

Development Banks are criticized, for the most part , for participating in a system where subsidies distort price signals; the wrong borrowers receive the subsidies anyway, and the bested interests perpetuate the system. These features indicate that directed credit systems are ineffectively operated and cause waste.