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What Are Development Financial Institutions?

Lakshmi Sandhana
Lakshmi Sandhana

Development financial institutions, or DFIs, are financial institutions that actively allocate money and resources to promote sustainable development and economic growth in developing countries. Backed by more developed countries, DFIs channel funds and provide various financial services such as guarantees, loans, and equity positions. They are different from aid agencies because they have a twin mandate to encourage development and make profitable investments. DFIs are responsible for investing in companies or projects in developing countries where banks and other institutions are hesitant about providing financial aid.

The concept of development financial institutions came into being to address the problems faced by emerging economies when it comes to development. Most developing countries have poorly structured financial institutions that aren't equipped to provide aid to growing companies and budding investors. It was considered too precarious to leave the very real need for development at the hands of variable market forces in these places. The governments in developed countries decided to create DFIs to serve as catalysts and finance industrial projects that are typically quite risky.

Man with a backpack
Man with a backpack

The whole area of development financing is considered to be so risky because there are a variety of factors that can cause the project to fail. Change in government policies, primitive infrastructure, and technology becoming obsolete are a few reasons. Competition from others, natural disasters, and poorly skilled labor are some of the other factors. Banks and other institutions are typically averse to investing under these conditions, given the uncertain outcomes. Development financial institutions fill this gap and provide long-term loans with long maturity periods.

These institutions also give loans at lower rates of interest and have means in place for underwriting losses. They don't have to pay any corporate taxes and can invest in projects that commercial banks would avoid. DFIs promote international cash flow finance investing in both small and medium-size companies. Development financial institutions can take the form of community development financial institutions and microfinance companies. They have a very challenging role because of their contradictory values.

DFIs are required to make a profit on the private capital used for investment and also invest in risky propositions in developing markets. They also have to be careful to make sure they do not put off private investors because of their own subsidized financial products. Some of the development financial institutions have strict rules against competing with banks and private sector terms. Yet, they are required to be on the lookout for underinvested projects in developing countries that also have social returns. These organizations can provide credit risk guarantees and high-risk equity investments while also mitigating risk.

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