Hard lessons for banks and FIs from a decade of bad infrastructure loans

Loans to the sector became huge NPAs largely due to the practice by lenders of offering unconditional mobilisation advance and time gap between preparation of a DPR and awarding the bid

How does a corporate loan become a bad one? Or, have the loan appraisals at banks improved, or is it just plain luck that the level of non-performing assets in the financial sector has come down! 

The process of loan evaluation is usually a black box. There are some exceptions. For instance, we know that the ratings of a company play a critical role in deciding the rates of interest that will apply. Or the classification of the sector as infrastructure. On the flip side, a high risk one affects the rates too. If it is the former, the rates dip even more. 

From Business Standard, we asked officers of an all-India financial institution to walk us through a loan process for an infra firm. Typically loans begin to go sour, said one of them, on the first day of disbursal. “Lenders were giving about 20 per cent of the total project cost as mobilisation advance without bothering to adjust it later against actual physical progress,” the person added. 

Loans to the infrastructure sector became huge non-performing assets through most of the last decade, despite several permutations tried by the regulator, the Reserve Bank of India. Speaking at a CII session in 2020, RBI Governor Shaktikanta Das said, “We are just recovering from the consequences of excessive exposure of banks to infrastructure projects. Non-performing assets relating to infrastructure lending by banks has remained at elevated levels”.

One of the reasons bankers said was this practice of offering an unconditional mobilisation advance. The advance was meant to be squared after 90 per cent of the project was completed. For projects where the promoter lost interest or wanted to play AWOL soon, this was a tantalising offer to capitalise on. 

Once this advance was on the books, the financial liability of the project became a joint responsibility of the lenders along with the developers. It forced the banks and financial institutions to keep on releasing more money, far ahead of the actual pace of the physical construction of the project. 

The other problem was the time gap between the preparation of a detailed project report (DPR) by the ministries or authorities and when the bid was awarded. Developers made it a practice to tell banks the cost estimates of a DPR had to be almost doubled, to make a project viable. Coupled with the generous mobilisation advance, the incentive to delay the timeline of a project was enormous. 

Gaming the system 

The NPA crisis has taught the financial institutions to insist that ministries and departments should be able to define precisely the criteria for a bidder to emerge as the least cost bidder. Simultaneously they have learnt to ask the bidders to ask difficult questions like who owns the land when filling their response to a request for a proposal (RFP) opened by a government department. 

“Now we insist that the total project cost should be equal to the bid value,” explained a bank source, who participates in all the project analysis. The bidders do not have the luxury to expect that the DPR will be revised since it has got dated. 

In 2018, fed up with the tendency of bidders to revise upwards their demand for loans from the DPR, the country’s largest lender State Bank of India forced a change of pace. Then chairman of SBI, Arundhati Bhattacharya passed instructions that no projects should be accepted by banks if the demand for its loan exceeded the DPR by 20 per cent. “The market changed drastically, in response”, said another bank credit officer. Bidders began to push the ministries to offer a realistic RFP in their DPRs. 

Once the bidders feel the cost numbers in the project makes sense, they sign a concession agreement with the ministries or departments to build the asset. Those assets could be roads, ports, a railway station or a warehouse. 

After a concession agreement is signed, the bidders get a timeline of 150 days for annuity projects or 180 days for a build operate transfer project to tie up their finances with a bank or other financial institution. Most bidders at this stage scout for a consultant to prepare their documents to approach the lenders. The documents they need at this stage are the project information memorandum, the financial model including the justification for the costs they have bid at and the equity they are infusing with a minimum set of papers to reach any lender. 

It had become tricky for the lenders to assess the project, however. To protect the bank’s balance sheet, the total interest cost is also included in the total cost of the project. “It is tricky terrain”, said a consultant. Parliamentary committees have often complained that this practice hurt the cash flow for the borrower. But given the risk environment surrounding an infrastructure project, the bankers think otherwise. It also makes them more amenable to offer a generous mobilisation advance. Even if the developer tripped, the actual exposure of the financial institution to the project minus the interest cost, would be lower than the headline numbers suggest. In other words for a Rs 100 crore project, the actual lending would be closer to Rs 90 crore if the rate of interest was about 10 per cent. 

This practice created an adverse risk selection by the borrowers. Since they knew there would be a high interest burden on their loans, they tried to deflate the cost of the actual construction of the project. 

So, here was the deal. The bankers saved themselves by packing in the cost of the interest in the gross loan amount , the borrowers (project developer) cushioned themselves by underquoting the cost of the construction and finally, also extracted a mobilisation advance ab initio to keep their cash flow easy.  No wonder the actual pace of the cost of construction suffered. 

Lessons learnt: 

It is no surprise that some of these problems have eased up with RBI moving to a softer interest rate environment—rates of interest even for triple B minus entities that ranged an average of 14 per cent a few years ago, have eased closer to eight per cent now. Simultaneously, agencies like the National Highways Authority of India have instituted what is known as milestone linked performance based bank guarantees. Instead of offering the earlier mobilisation advance this system ensures that the borrower can get money only if they demonstrate commensurate levels of physical progress. “The gap between the financial pay out and the construction gets narrowed with each milestone’, said an expert in project finance. NHAI encourages about 10 such milestones in the life of a project. Other entities like railways and ports are moving in a similar direction. 

"In Hybrid annuity projects we deduct the government support to arrive at the loan value. And we ask for valuation reports from independent engineers, vet the loans through legal trustees and finally incorporatie the best practices from other lenders", said the project finance expert. 

Also, the lenders now insist that the loan value asked for by the bidder should not differ from the project cost as articulated in the DPR. This congruence should include the engineering, procurement and construction costs and the additional costs like insurance which form a set of pre-operative costs. Matters have been helped as NHAI and others now do not delay the timeline from the firming of the DPR to the bidding out of the project. 

It has also become common for the lenders to link lower equity from the developers to a higher rate of interest. “The construction period offered for any road projects is as low as 18 months. As this spread has come down, the timeline risks have become lower for the lenders”. It has created a new class of risk—faster completion could lead to cutting of corners, but that is something which will need to be tested later. As of now the small society of lenders are happy with the higher discipline among the borrowers.