Tweak draft project loan financing norms

On May 3, the Reserve Bank of India (RBI) released a draft direction outlining the prudential framework for project loan financing. The objective is to strengthen the existing regulatory framework and harmonise the norms across the lending community, including all kinds of banks, financial institutions, and non-banking financial companies (NBFCs).

The regulator has invited comments on the draft direction by June 15. Better late than never. Let me offer some comments and feedback through this column.

Indeed, there are many positives in the draft norms. For instance, in projects financed under consortium arrangements, where the aggregate exposure of the participant lenders is up to Rs 1,500 crore, no individual lender shall have an exposure of less than 10 per cent of the aggregate exposure. For projects where the aggregate exposure of lenders is more than Rs 1,500 crore, the floor for individual exposure is fixed at 5 per cent or Rs 150 crore, whichever is higher. 

This will help lenders manage the risks better. One of the key reasons why public sector banks ended up with a high volume of bad loans in this segment in the last decade was their herd mentality. Whenever a large bank took exposure to a project, relatively smaller banks rushed to join the band of lenders without appreciating the risks to their balance sheets.

Lenders wishing to engage in project financing must have a board-approved policy for the resolution of stress in projects if they turn bad. They are also expected to continuously monitor the build-up of stress in the project and initiate a resolution plan well in advance.

In the eye of the storm is the proposal to raise the provision requirement by more than 12 times – from 0.4 per cent to 5 per cent of the outstanding as well as fresh exposure during the construction phase of a project. Once a project reaches the operational phase, the provision can be halved to 2.5 per cent. It will be reduced further to 1 per cent when the project’s cash flow can meet the repayment obligation to all lenders, and the long-term debt of the project declines by at least 20 per cent when it starts commercial operations.

The rationale behind such a measure could be that lenders have been evergreening their exposures to under-construction and delayed infrastructure projects. The 5 per cent provisioning during the construction will be achieved in a phased manner: 2 per cent by March 31, 2025 (spread over the four quarters of 2024-25); 3.5 per cent by March 31, 2026 (spread over the four quarters of 2025-26); and 5 per cent by March 31, 2027 (spread over the four quarters of 2026-27). 

Non-compliance will attract supervisory and enforcement actions.

As banks will need to set aside more money due to the rise in provision requirements, their cost of funds will increase. This will have a cascading effect on both infra lenders and investors. Typically, the return from such projects for the lenders is around 9 per cent and, for the investors, it’s around 15 per cent. The debt-to-equity ratio for infra projects varies, depending on its nature, but roughly 70:30 is the norm. Public-private partnership (PPP) projects are usually financed on this ratio of debt and equity.

With the rise in the cost of money, the cost of loans for project finance will rise as no lender would like to compromise on profitability. Analysts predict the impact could be between 0.5 and 0.7 per cent, depending on the balance sheets of the lenders. Regardless of the exact figure, an increase in the cost of debt will shrink the return for investors and may also impact the flow of foreign funds.

Immediately after the draft norms were released, bank stocks took a beating, as did some NBFC stocks such as Power Finance Corporation Ltd, REC Ltd, and Indian Renewable Energy Development Agency Ltd. While the Nifty PSU Bank index dropped 3.2 per cent, some NBFC stocks in this space crashed by 10 per cent or more.

If the draft norms on higher provision requirements for under-construction projects are implemented, private banks, foreign banks, and NBFCs could develop cold feet for infra financing. They will look for other sectors that can fetch better returns. Consequently, the burden of project financing will shift back to public sector banks and the National Bank for Financing Infrastructure and Development. One of the reasons behind public sector banks’ huge bad loan pile in the last decade was their massive exposure to project financing, often without understanding the risks.

Can the world’s fastest-growing economy afford to compromise on building infrastructure? No. Are there risks involved? Yes. But we can have a different approach to mitigate these risks. Let’s not kill the goose that lays golden eggs.

Instead of a blanket 12-fold jump in the provision requirement, the RBI can ask lenders to create project finance reserves on their balance sheets. These dynamic reserves can be used if a lender sees bad loans rising in this sector. If not, they should be allowed to write back the money to bolster their profits. This could be a solution that allows the regulator to have its cake and eat it too.

Overall, the theme of the draft norms is prescriptive. For instance, it says that the financing agreement will generally not allow any provision for a moratorium on repayment beyond the date of commencement of commercial operations. In cases where a moratorium on repayment beyond the date of commencement of commercial operations is granted, it should not exceed six months. Finally, the original or revised repayment tenure, including the moratorium period, if any, cannot exceed 85 per cent of the economic life of the project.

On what basis was the six-month period decided? Shouldn't it be left to the lenders to decide this? It seems the regulator doesn’t trust them at all.

Similarly, the draft norms introduce the concept of net present value (NPV) for projects. A positive NPV is a prerequisite for any project that lenders want to finance. A fall in NPV during the construction phase, due to changes in projected cash flows or time overrun, among other factors, can happen. This will be construed as a credit event (default). Lenders will have to get the NPV of all projects independently re-evaluated every year.

Time and cost overruns are part and parcel of any infra project, but the NPV could be subject to interpretations. RBI auditors may find the NPV of certain projects lower even after independent evaluation. If that happens, lenders will have to classify the exposure as a bad loan and provide for it. According to a Ministry of Statistics and Programme Implementation report, as of March 2024, 42 per cent of the Union government’s existing projects have reported delays, while 24 per cent have experienced cost overruns.

The draft guidelines are the RBI’s maiden attempt at providing a comprehensive regulatory framework for project finance in India. They cover the entire life cycle of a project and introduce many new requirements for lenders. While some of these are necessary, not all are. These steps are probably welcome from a supervisor’s point of view, but shouldn’t the regulator also play a developmental role? If it wears that hat, it will see logic in tweaking certain norms while drafting the final guidelines.


The writer, a consulting editor with Business Standard, is an author, and senior advisor to Jana Small Finance Bank Ltd. His latest book is HDFC Bank 2.0: From Dawn to Digital. He tweets as @TamalBandyo