RBI's change in project finance rules may sow the seeds of a future crisis

The Reserve Bank of India’s (RBI’s) recent project financing guidelines have led to much cheer in the stock markets. One highlight is that the provisioning requirement on project finance is now 1 per cent, instead of 5 per cent proposed in the discussion paper issued earlier. Many lenders feared that a blanket requirement of 5 per cent, provisioning would absorb all capital and slow down lending. Thus, the RBI has avoided a short-term slowdown in economic activity. However, are these guidelines net positive from a long-term point of view, or are some tweaks necessary, given our experience of the Indian banking crisis between 2008 and 2018? My focus here is on the provision that allows lenders to grant extensions to projects that miss their pre-committed commencement timelines.  

 

Let us first understand the basic structure of project financing. A typical project goes through three phases, namely, the design phase, the construction phase, and the operational phase. The project is conceived and planned during the first phase. Prospective lenders evaluate the plan prepared during the design phase and approve or disapprove project finance. In case they approve, they also finalise the terms of the loan.

 

The loan terms usually recognise the existence of a construction phase when the project is being built. Given that the project does not generate any revenue at this stage, loan repayment generally starts after the construction is over and the project has begun operations. The expected date of starting operations is known as the date of commencement of commercial operations (DCCO). It is not difficult to imagine that, for several reasons, a project may not be able to start on the DCCO as planned several years earlier. The crucial point here is that if the DCCO is delayed, the borrower will not be able to repay the loan on the originally agreed schedule. What lenders should do in such a case is the main subject of the circular.

 

A strict way of dealing with such loans is to classify them as non-performing assets (NPAs) and start recovery proceedings. Recovery proceedings could lead to borrowers being dragged to the bankruptcy court and even the liquidation of their assets. To understand why such a strict approach may not always be socially beneficial, consider a project that requires rare earth minerals as inputs. Assume that the project was supposed to be completed this year. Now that China has unexpectedly restricted the exports of those materials, the project is stalled and misses the original DCCO. It is easy to see that there is a realistic possibility of the rare earth minerals issue being resolved shortly, either by India coming to some kind of agreement with China or by securing other sources of supply. So, if the bankers had granted an extension to the DCCO, the project could have been saved instead of selling its assets piecemeal at fire-sale prices. This would have been advantageous to society, as the best users of capital would have used the capital, maximising production and employment. Even the bankers would have recovered their full overdue amount in due course.

 

If extending the DCCO is a win-win solution, why not do it in all cases? To understand the downside of blanket extensions, consider a borrower whose DCCO is delayed due to mismanagement. In such cases, bankers are better off declaring the loan an NPA and initiating recovery proceedings. Giving more time to incompetent borrowers would mean further mismanagement and eventually lower recovery for the banks. In some cases, borrowers may even steal assets pledged to the banks. Even social welfare is likely to be enhanced if the assets are passed on to a more efficient user of capital through bankruptcy or liquidation proceedings.

 

Unfortunately, the RBI circular does not distinguish between the two types of reasons due to which projects may get delayed: It allows lenders to extend the DCCO without recognising NPAs even when the reason for the delay is not a liquidity shock. While allowing DCCO extensions for liquidity shocks is welcome, extending the same concessions when the reason for delay is within the control of management could lead to misuse and be socially harmful.

 

I recognise that it is hard for the RBI to define and distinguish between liquidity shocks and fundamental shocks. However, lenders can be asked to have a board-approved policy of identifying liquidity shocks and establish a process where the DCCO may be extended only when they are convinced that the delay is due to such shocks. The officer in charge should be asked to describe the liquidity shock, and a competent authority should be asked to review it. The RBI, for its part, can review the policy followed by lenders. This way, best practices may emerge. A blanket extension of DCCO may sow the seeds of a future crisis.

 

The author teaches finance at Indian School of Business. The views are personal