Financial Institutions and their role in the Process of Economic Development


The devastation caused by the Second World War and the resulting need for very large finances to restructure and rehabilitate damaged economies, made it necessary to form new financial institutions, even in European countries. Their role was to provide finance for small, medium and large scale industry, not only for regional and sectoral development but also for social purposes and infrastructural development. This paper contends that Financial institutions and their role in the process of Economic development.

Created credit enables entrepreneur to proceed with his innovation in anticipation of savings. Bank credit plays a critical role in stimulating economic development.”

—– Schumpeter


The objective of any development strategy, particularly in capital scarce developing countries, is to raise considerable financial resources required to improve the standard of living, employment generation and national output. The huge amount of finance required for over all economic development could not be met by Government itself. It is in this context, the concept of development banking came into the picture with the object of mobilising resources from the internal (public) and external sources besides government. Imbalances in the distribution of development and wealth also necessitated specialised institutions  backed by public funds to correct lopsided socio-economic development. In the early 1940s the need to reduce the gap between the standards of living of the developing countries in Africa, Asia and Latin America on one hand and those in Europe and North America on the other, brought about the need for more conscious promotion of economic development by means of development financing institutions.

With the attainment of independence by many developing countries after the Second World War, the need to accelerate the process of economic development became more prominent and pressing. Rapid growth of population, adoption of western style of living and consequent increase in fashions, styles and wants added to the urgency of having variety in economic production. Emphasis was placed on industrialisation as a means of achieving faster economic growth. However, the necessary ingredients of development viz., capital, information on investment opportunities and local entrepreneur were absent. These inadequacies inhibited private initiative in new areas of economic activity that appeared risky. Consequently, vicious cycle of inadequacies formed from which there appears to be no escape for the Third World Countries. In the words of Franklin Root.

“Productivity is low because investment is low; investment is low because savings are insufficient; savings are insufficient because incomes are low; incomes are low because productivity is low.

There is an important angle to the role of financial institutions in economic development, particularly of banks, which has been popularised by distinguished economists like Schumpeter, Kalecki and Keynes. He wrote, “the banker, therefore, is not so much primarily a middleman in the commodity `purchasing power’, as a producer of this commodity. Newly created purchasing power by banks placed in the hands of the entrepreneur enables him to secure command over physical resources and thus push through his investment projects. Once the investment results in the increased production, the initial credit inflation disappears and  the equivalence between money and commodities streams is restored. Both Kalecki and Keynes regarded the availability of finance as a key factor in ensuring independence of investment from savings. Schumpeter had vehemently emphasised the crucial role of credit institutions in the financing of innovations and thus facilitating economic development.

So that the advent of `Development Banking extended the horizon of the mobilisations of scarce resource (capital) nationally and internationally and succeeded to a greater extent in stimulating the economy and industrial output on one hand and correcting the lopsided structure of the economy on the other. But along with industry other major sectors like agriculture, infrastructure, transport, education and health also require a considerable increase in capital investment, since industry itself cannot grow in isolation.

By providing resources for investment in infrastructure, agriculture and industry, development banks play a prominent role in diversification and distribution of income, employment and output more effectively. Perhaps this may be evident from the recent past that considerable progress has been made by numerous countries in this regard.  It is but natural as finance has the strength to command all resources and direct their flow in socially desirable directions. Development banks are thus acting as a catalyst for the pace of industrial growth and for promoting industries by development in otherwise industrially backward regions.

Besides performing the financial functions, financial institutions also provide entrepreneurial assistance to the individual entrepreneurs/projects, act as an agency for securing foreign technical advice and raising funds from the capital markets of advanced countries. The institutions also facilitate the expansion of markets through distributive techniques and undertake other promotional jobs of an essential nature, such as, marketing and investment research surveys, techno-economic feasibility and cost-benefit studies of different growth sectors or a region, particularly the backward regions of the country so as to identify potential for economic growth.

Prior, industrial finance by development banking is highly preferable as it rises productivity, income and standard of living, capital formation and national output besides employment generation. The development banks also can prevent the concentration of economic power and be successful in promoting the indigenous growth of small entrepreneurs.

Thus, financial institutions not only help in mobilisation and collection of scattered savings from different sections of population, but they also help to increase the overall level of savings and investment and allocate more efficiently scarce savings among most desirable and productive investments in accordance with the national priorities.

Evolution of Financial Institutions in India

Therefore, it required a lot of imagination, effort, enterprise, determination and the supporting institutional framework so that a sustained and well-diversified industrial growth could blossom to meet the objectives of Indian planning, national priorities and national aspirations.

In the period that followed, there was a rich crop of new institutions in the background of the Five Year Plans. These also included the financial institutions which marked a sharp break with the past and the erstwhile stagnating tendencies in the Indian economy. The direct government investment in agriculture, industry, education and infrastructure opened up a new vista of investment opportunities on a broader front and on a much larger scale. “This called for efforts in other areas to convert the emerging opportunities and catalyses the growth impulses into productive enterprises. For realising these objectives, there was a special role to be played by the financial institutions insofar as the financial input of the right magnitude, right types, and at accessible sources was the missing link around which the human and material resources could be harnessed to generate increasing volumes of real outputs and services”.

As a result of the developmental programmes spread over a long chain of Five Year Plans which cover up the entire country and touch almost the entire gamut of the socio-economic aspect of the country it has now been possible to overcome the bottlenecks to growth to some extent. It has set the stage for the financial institutions from where they can take a leap forward to be face to face with the new challenges in the economy.

The Indian banking system which has developed under the influence of British banking practices had not been well disposed to extending term loans to industry on any significant scale. It was for this reason that immediately after independence, the Government of India decided to set-up the Industrial Financial Corporation of India in 1948. In view of the immensity of the task of industrialisation and the vastness of the country, subsequently it was necessary to establish a regional bank for each one of the States and the State Financial Corporation Act was passed by the parliament in 1951. The National Small Industries Corporation was set-up in 1955 to assist small scale units through promotional financing and other activities. During the same year, the Industrial Credit and Investment Corporation of India was set-up with a view to provide term loans in foreign currencies for industrial projects. The Life Insurance Corporation of India which was established by amalgamating the several private sector insurance corporations also continued to play a useful role in providing finance to industry.

The purpose of setting up the Industrial Development Bank of India in 1964 could be best described in the words of the then Finance Minister of India, Shri. T.T.Krishnamachari who said, while introducing the bill on IDBI in the parliament that “Where a long – term view is necessary and a certain amount of risk has to be taken, the existing institutions tend, by reason of their statutory obligations and traditions, to be conservative and cannot in any case be very helpful. We are envisaging the new Industrial Development Bank as a central co-ordinating agency, which ultimately will be concerned, directly or indirectly, with all the problems or questions relating to long or medium-term financing of industry and will be in a position, if necessary, to adopt and enforce a system of priorities, in promoting the future industrial growth”. Simultaneously, the Unit Trust of India was also established with a view to providing an outlet to private risk capital which was shy in entering into equity investments.

All these development banks which have come into existence are set-up primarily to provide long-term finance though some of them, like the IDBI are not precluded from giving working capital funds. Despite the flexibility of their objectives of incorporation, development banks have continued to focus their attention primarily on providing long-term resources to industries. It contributed to economic development.


A financial system comprises financial institutions, markets and instruments which together provide the essential framework for mobilisation and allocation of savings. The primary role of any financial system is to act as a conduit for the transfer of financial resources from net savers to borrowers i.e., from those who spend less than they earn to those who earn less than they spend. Thus, the role of an integrated financial infrastructure in stimulating and sustaining economic growth is well recognised now. A network of financial institutions helps an economy to augment its savings. At the same time it leads to a more efficient utilisation of the available investible resources. Thus, a sound and efficient financial system can contribute to economic growth and development in a number of ways.

The Indian financial system has undergone a remarkable transformation over the last six decades and now comprises an impressive network of financial institutions – mainly in the public and co-operative sectors – financial markets and a wide range of financial instruments. The system has become more sophisticated in response to the varied needs of the economy. Now India has been successful at developing a large financial sector, and one of the largest capital markets in the developing world.


  • Jai Prakash and Dr. Babita Vedic, Employment Generation Through Industrialisation, Mohit Publications, New Delhi, 1998.


  • Uppal, J.S., Public financial institutions In India, MacMillan India Limted 1984.


  • Myrdal, G., The Economic Impact of Colonialism in Developing the Under Developed Economies, edited by Allan B. Mountjoy Macmillan, London, 1971.


  • Leembruggen, H.F.G., Government/Development Bank Relationships in Semi-Industrial Developing Countries, Published in Development Banking in the 1980s, United Nations Industrial Development Organisation, New York, 1980.


  • Quoted in Development Banking in the 1980s United Nations Industrial Development Organisation.


  • Schumpeter, J.A., The Theory of Economic Development, Harvard University Press, 1949.


  • Klaus Jacobi, Welcome Address in World Bank Symposium, vide Development Banking in the 1980s.


  • Dave, S.A., Social Obligations of Development Banking, United Nations Publication


Dr. Kanuparthi Ramanaiah, M.A. Ph.D.
SRT 91,1-1-379/160, Jawahar Nagar, R.T.C.’X’ Roads, Hyderabad

Published : Banking Finance Magazine – February 2013

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