An increase in risk weightage by 1250 per cent! This is effectively what the RBI has proposed by setting a provisioning requirement of 5 per cent for all project loans, up from the current 0.4 per cent, as stated in its May 3 draft Master Direction on income recognition, asset classification, and provisioning related to projects under implementation.
Most discussions have centered on the absolute level of provisioning rather than the implied risk perception suggested by the proposed norm. A 5 per cent provisioning levy equates to increasing the risk weightage to 1250 per cent (5/0.4). The impact on the P&L accounts of a project lender will be identical — the amount will need to be reallocated from earnings to liabilities, to the Provision account or to the Capital account.
From this perspective, it is evident that the RBI perceives higher risk in funding projects in both the infrastructure and non-infrastructure segments. The draft Direction applies to banks, NBFCs like REC and PFC, and all-India financial institutions like Nabfid, and allows the 5 per cent provisioning to be achieved gradually by 2027.
Lenders shouldn’t worry excessively. In fact, prudence would dictate that they seek approval from their Boards for a higher provisioning of perhaps 7.5 per cent or 10 per cent for project finance exposures. Logically, if the regulator hints at increased risk, lenders should be proactive.
Pricier loans
How will lenders manage this additional cost? They will pass it on to the borrowers. New loans will naturally be priced higher, and only projects with sufficient cash flows to service this high-cost debt will secure funding. This aligns with the regulator’s risk assessment, and lenders should comply.
The challenge lies with existing loans where pricing decisions have already been made and debt service coverage ratios established. The risk-adjusted return on capital assumption is likely to go for a toss because of the provisioning impact. The RBI may allow a special dispensation for ongoing projects, either lowering the requirement or permitting lenders to charge more than initially contracted, in proportion to the higher provisioning.
Regardless, for all project loans, various stress tests are part of the appraisal process, and the higher provisioning should ideally fit into one of these scenarios. In existing projects, if project viability is compromised due to higher provisioning, it would indicate that debt servicing projection was already precarious.
Often, lenders even accept debt coverage ratios barely above 1 (cash flows upon repayment), citing mitigating circumstances. Such loans will now face difficulties if the draft is fully implemented.
Clearly, the overall impact on the project finance market and economic growth through projects would have been considered by the regulator before proposing the 5 per cent provision. The RBI also has a growth mandate, although recently, its role in inflation targeting has overshadowed this due to the focus on MPC decisions.
Complex directions
The provisioning norm is actually the least problematic and easiest to implement among the norms proposed in one of the most complex directions ever drafted by the regulator. No lender could be blamed for feeling that the guidelines, with their detailed treatment of exogenous and endogenous risks, resemble a biochemistry chapter more than one on income and asset parameters.
If the regulator had aimed for simplicity, it could have stuck to the 90-day default norm, which is clear-cut and widely accepted. If a project doesn’t generate cash flows but promoters inject funds to service the debt, it should not be a problem.
Why the emphasis on the date of commencement of commercial operations (DCCO) and its extension (and the preservation of Net Present Value too), now defined as Credit Events in the draft? Lenders and borrowers should have flexibility with the DCCO and allow NPV fluctuations, while the regulator should focus solely on the 90-day default norm for clarity.
If necessary, a simple logic could have been proposed for DCCO extensions, specifying perhaps just two time periods for infrastructure and non-infrastructure projects. The direction now divides the DCCO deferment into three categories — endogenous, exogenous, and legal— with additional caveats. Questions arise, like why litigation is treated separately when exogenous risks already cover law, regulation, and policy.
In a return to a rules-based regulatory approach, the draft meticulously specifies the norms lenders should follow in their credit administration for project loans. Any rule will contain potential loopholes.
For instance, consider the following stipulations:
For cost overruns, asset classification benefits are available only if the cost increase is 25 per cent or more. (Loophole: Even if additional costs are actually lower, there is an incentive to pad up costs.)
A standby credit facility can be sanctioned up to 10 per cent of project cost. (Loophole: Without a minimum margin stipulation in place, project costs can be initially inflated to secure a higher standby facility.)
Lenders should generally not allow any moratorium beyond the DCCO. (Loophole: Borrowers might set a DCCO that exceeds expectations to get a longer moratorium.)
Other complexities in the proposed guidelines include a special dispensation for PPP projects (requiring only 50 per cent land availability for financial closure). Without a clear definition of PPP projects (does 5 per cent public sector participation suffice?), this could cause friction during supervisory reviews. Also, why have endogenous factors been given more regulatory forbearance than exogenous factors for DCCO extension? Logically, projects should get more forbearance for delay caused by factors outside the control of promoters. Perhaps, RBI has a rationale.
Ambiguous or complex guidelines often lead to interpretation issues during supervisory reviews. A round-table discussion on the draft — with industry, lenders, and other stakeholders — where the regulator explains the rationale for each clause, including the provision norm, could result in a workable, clear-cut, simple, and unambiguous final version. Both lenders and borrowers deserve better.
The writer is a commentator on banking and finance