How to make the DFI model work

In her recent Budget speech, Finance Minister Nirmala Sitharaman proposed to revive development financial institution (DFI) model to act as a provider, enabler and catalyst for infrastructure financing.

The government provided ₹20,000 crore to capitalise the DFI to meet its ambitious loan target of ₹5-lakh crore within three years. After the transformation of the erstwhile DFIs — Industrial Development Bank of India (IDBI) and Industrial Credit and Investment Corporation of India (ICICI) — into universal banks, there was a vacuum in the DFI space, in general, and infrastructure financing, in particular.

Though banks and other financial institutions have been purveying term loans and project finance for infrastructure projects, there exists a gap in long-term funding in terms of appraisal skills, asset liability mismatches, and adequacy of low cost funds.

Total outstanding loans to infrastructure sector stood at ₹10.54-lakh crore as of March 2020. As infrastructure facilities (both hard and soft) have a multiplier effect on the economic growth and development, the DFI model is sine qua non for realising India’s dream of becoming a $5-trillion economy by 2025. Can the DFI model succeed in India?

Corporate governance

By taking advantage of hindsight, the proposed DFI can be established as a professionally managed organisation with minimum scope for political interference. The government can opt for a ‘holding company structure’ and seek private equity participation from institutional investors which can bring in technical expertise and professionalism in addition to capital for the DFI.

Subsequently, the government may look at listing the DFI through an initial public offering, after five years, for better corporate governance, constant monitoring by market forces and prudential supervision by the regulator.

In this context, Raghuram Rajan, former Governor of Reserve Bank of India, had called for operational independence for the boards of banks/financial institutions , so the holding company can appoint the board of directors based on ‘fit and proper criteria’.

Focus on human resources

Banking is a function of knowledge, skill, experience and wisdom. Several research studies have found that senior credit officers with adequate experience and commercial judgement may either retire over a period of time or overlook the lessons learnt from the previous episode of bust, resulting in overall loss of learning experience and decline in institutional memory (due to passage of time).

Thus, bridging human resource gaps and managing attrition of employees with key skills are the major challenges of the DFI. To address this, the proposed DFI has to focus on continuous recruitment, experiential training and capacity building of its officers in credit appraisal, risk management, and loan recovery. As assessment of projects is distinctly different from appraisal of working capital requirements, DFI requires the personnel with superior project finance skills, in-depth technical knowledge and professional expertise about the industry and infrastructure domains.

Financial resources

DFIs such as Industrial Investment Bank of India (IIBI), and Industrial Finance Corporation of India (IFCI) could not succeed mainly due to their higher cost of funds (lack of access to deposits from the public) and absence of adequate monitoring of implementation of financed projects.

Besides, when the DFI transmits the higher interest rate to the borrowers, the assisted infrastructure projects become commercially unviable leading to spiralling of non-performing assets (NPAs) and the eventual failure of the DFI.

Infrastructure projects usually have longer gestation periods and are associated with huge uncertainty, and repayment of these project loans is dependent on its cash flows rather than realisability of the collaterals. Hence, the RBI can accord special status to the infrastructure sector and revise the 90-day NPA norm to 180 days.

Besides, DFIs require long-term funds for financing infrastructure, ranging from 10 to 30 years, resulting in asset-liability mismatches. As such, they need to mitigate risks such as interest rate risk, exchange rate risk, market risk, etc. in order to achieve sustainability.

Infrastructure Leasing & Financial Services (IL&FS) is the latest example of mis-management of assets and liabilities apart from lack of corporate governance. Banks also piled up NPAs when they tried to fund long-term projects against their short-term deposits.

The future path

Post-Covid, as the West has been weighing options to shift some of its global value chain activities from China, establishing world class infrastructure facilities is essential to develop India as a manufacturing hub.

As infrastructure sector has strong backward and forward linkages, investment in infrastructure is quintessential for inclusive economic growth. Since infrastructure falls under the ‘public goods’ category, DFIs should be nurtured as part of our nation building exercise.

Given the widespread asset-liability mismatches, RBI too suggested that excessive dependence on bank-based system, particularly for infrastructure financing may be reduced (Annual Report of RBI, FY 2019-20).

Policy paralysis in the past has been one of the key factors for the failure of many infrastructure projects. Hence, the government may look towards establishing an apex body that will facilitate land acquisition and other statutory clearances for the infrastructure projects to avoid time and cost overruns.

The government can also introduce tax incentives/sops for the investors on capital gains and income tax fronts, given the nascent stage of corporate bond market. RBI may also explore opening of repo window to utilise foreign exchange reserves for financing the infrastructure projects of DFI based on the latter’s asset book and natural hedging positions.

Development financing is a risky business. Understanding the business dynamics of the borrower/infrastructure projects is crucial before lending. One hopes that the proposed DFI will adhere to this and fly like Phoenix in the Indian financial markets.

Srikanth is Associate Professor and Director (Finance), DDU-GKY, National Institute of Rural Development and Panchayati Raj, Hyderabad, and Prabu is Assistant General Manager, State Bank of India, Chennai. Views expressed are personal.