A prudent gamble?

Significant changes to infrastructure finance

In his Budget speech, Finance Minister Arun Jaitley made a significant announcement relating to infrastructure finance. Banks would be exempt from cash reserve ratio, or CRR, and statutory liquidity ratio, or SLR, requirements if they raised money by issuing long-term bonds in order to lend to infrastructure projects. After some apparent reluctance initially, the Reserve Bank of India (RBI) seems to have taken to the idea, extending the broad exemptions to funds raised and lent to low-cost housing projects. The details apart, the main benefit of the exemptions from the banks' point of view is that their cost of funds will decline in the absence of the prudential load, which can then be passed on to borrowers. But it would be naive to think that such a channel would bring no risks into the banking system with it. It is necessary to weigh the pros and cons of what is really a significant change in the prudential regulation of the banking system.

There are - apart from the direct impact on borrowing costs - some other significant potential benefits. There has been a lot of hand-wringing about the development of a corporate debt market in India. A number of factors are responsible for this, and they have to be dealt with. This exemption creates a clear incentive for the issuance of long-term bonds by banks, which, at the early stages of a market, is a good way to go about it. On the other side of the equation, the Budget has also given incentives for investment into such bonds by lowering the withholding tax from 20 per cent to five per cent, in line with the regime for government securities. By simultaneously addressing both a supply and a demand problem, the Budget provides a boost to the corporate bond market. Perhaps it will get moving at last, on the back of issuances by banks.

But the risks should not be underestimated. First, for a bank its bond is its liability, on a par with any other liability such as deposits. If a bank is in trouble because a part of its portfolio is stressed, this could, if not guarded against, easily impact all creditors to the bank, including the depositors. This is precisely why prudential norms are applied across the entire liability base of the bank. In the proposed arrangement, some mechanism would have to be developed to ring-fence depositors from the default risk of the bonds. The RBI is clearly conscious of this spillover risk and has prescribed some protective measures against loans made from the bonds turning sour. But it does not hurt to be extra careful here. The larger concern is the overall state of the infrastructure sector itself. Even though bank-issued bonds are going to be more attractive than company-issued ones because bank portfolios are diversified across projects, if problems are common across all projects, asset quality risks remain significant. This may lead to the market demanding yields from the bonds that the projects funded by them cannot afford. In other words, what appears to be a solution is not really one. The best thing for all the stakeholders to do at this point is to objectively evaluate the benefits and risks that this relaxation of prudential norms engenders.