Back to term-finance institutions?

The Reserve Bank of India (RBI) has issued a discussion paper that moots the idea of long-term finance banks. This would amount to seriously turning the clock back to the early 2000s. 

We then had three development financial institutions (DFIs) that focused on term finance, namely, IFCI, ICICI and IDBI. Commercial banks confined themselves mainly to providing working capital. 

There were reasons for separating the two roles. Banks’ funds are mostly short-term in nature. So their getting into term finance results in long-term assets being financed by short-term funds. This exposes banks to interest rate and liquidity risks.

Secondly, providing project finance requires appraisal skills of a different sort from those required for providing working capital. Working capital is backed by assets that are easily liquidated. Not so project finance. You have to depend on cash flows to service the debt. This makes the evaluation of risk far more challenging.  

Term-finance institutions have to rely on long-term funds. This means more expensive funding and hence costlier loans. The DFIs could get around this problem because they were given access to low-cost funds — from the RBI and through bonds guaranteed by the government and that qualified as statutory liquidity ratio (SLR) securities. 

At their peak in the late 1990s, the three DFIs accounted for nearly a third of gross fixed capital formation in manufacturing. Most of the loans were made to manufacturing. Lending to infrastructure accounted for just 15 per cent of the total. (Deepak Nayyar, Economic and Political Weekly, August 15, 2015).

Financial sector reforms in the mid-1990s meant that concessional funding was out. Banks were allowed to venture into long-term funding. DFIs were then reeling under the impact of bad loans of the past. These together undermined the DFI model. 

The idea that working capital and long-term finance should happen under one roof took hold. The second Narasimham committee on financial sector reforms (April 1998) and the S H Khan Working Group (May 1998) both recommended that the roles of DFIs and banks be harmonised.

The RBI was not entirely convinced. In a discussion paper published in January 1999, the RBI warned, “Drastic changes in their (DFIs’) respective roles at this stage may have serious implications for financing requirements of funds of crucial sectors of the economy.”

Nevertheless, the RBI chose to fall in line with the Narasimham committee recommendations — it is often said, under pressure from the international agencies that had provided structural adjustment loans. The RBI advised the three DFIs to convert themselves into banks or non-banking financial companies (NBFCs). ICICI and IDBI opted to merge with their banking subsidiaries. IFCI muddled along and eventually became an NBFC.

In Japan and many East Asian economies too, the role of DFIs was curtailed over time. But this happened only after certain conditions had been met: A high savings rate, large foreign direct investment (FDI) flows and considerable growth in domestic capital markets. The Indian economy had not met these conditions in the early 2000s. Doing away with DFIs at that point was thus rather premature.

The RBI discussion paper seems to acknowledge as much. It argues that, in recent years, bank lending to the services sector, industry and small and medium-sided enterprises (SMEs) has suffered thanks to the bad loans on their books. It says that banks lack the expertise necessary for term finance. There is a need for term-finance institutions to fill these gaps.

The proposed term-finance institutions would have a minimum capital requirement of Rs 1,000 crore, higher than the Rs 500 crore stipulated for commercial banks. They cannot have savings accounts but they can have current accounts and term deposits with a minimum of, say, Rs 10 crore. They would be exempt from cash reserve ratio (CRR) requirement for funds raised through infrastructure bonds. These funds would also need to be exempted from SLR requirements in line the relaxation given to commercial banks. 

The key question, which the paper sidesteps, is: How do we ensure viability? 

If the proposed term-finance institutions are to raise finance entirely from the markets, it will make their loans far too expensive. Banks may be leery today of financing projects at the outset. However, once a project is close to completion, they are happy to refinance loans at lower rates. This is happening with power projects, for instance. Term-finance institutions may not be viable as long as they face higher borrowing costs than banks. 

To be viable, they will need to access concessional funding through government-guaranteed bonds and low-cost funds from the international agencies. So, yes, there is room for a term finance institution but only one that is promoted by the government and gets subsidised funding — in effect, a new avatar of IDBI. 

Will the government have the stomach for an initiative that looks distinctly anti-reformist? Would it want to promote a new financial institution at a time when it wants to shrink the numbers of those that obtain today?
 

The writer is a professor at IIM Ahmedabad 

ttr@iima.ac.in