BS READS: Some mistakes India must avoid this time to make DFIs a success

Now that DFIs are making a comeback, three key issues will be crucial for their success -the availability of long-term funds at a reasonable cost, private-sector ownership, and professional management

Among the key reasons why development finance institutions (DFIs) could not survive in their earlier avatar was that a scarcity of long-term financing made the business model of such entities unviable. Now that DFIs are set to make a comeback, with the Union Budget proposing to set one up, three key issues seem crucial for their success – the availability of long-term funds at a reasonable cost, private-sector ownership, and professional management.
 
According to bankers, DFIs failed earlier because, among other things, a drying up of long-term financing prompted them to turn to banks for their financing needs. This inflated their cost of raising funds. As banks’ deposits were for the short term, they could not provide the longer-term funding that DFIs needed, thanks to asset-liability mismatch concerns. More than 40 per cent of bank deposits are for less than a year, while 20-25 per cent of them are for more than five years.
 
DFIs need long-term funds because they are involved in financing infrastructure and industrial projects, which usually have a long gestation period. India has seen many DFIs in the past, but many of those were later turned into commercial banks – IDBI, ICICI and IDFC to name a few.
 
S S Kohli, former chairman and managing director of India Infrastructure Finance Co Ltd, (IIFCL), told Business Standard: “The first thing is that the cost of borrowing earlier was very high. That should be taken into account... if you want to grow infrastructure, the funds should be available at a reasonable rate.”

 
If DFIs were to raise long-term financing earlier, they could do so by floating 10-year papers, given that they were in a position to sustain long-term liability. But the behaviour of investors began to change amid various risks associated with long-term papers, particularly the interest-rate risks, as the rate cycles became shorter.
 
“There was a time when interest rates would remain undisturbed for 10 years,” said Ashvin Parekh, ‎managing partner, ‎Ashvin Parekh Advisory Services LLP. “But then came a time when the horizon became shorter: With the development of the inter-bank market, a lot of call money came into the economy. Long liability by institutional investors was no longer available. The change that started from 1995, took deep roots by 2000-2001, and investors for long liabilities became fewer and fewer.”
 
The Budget this time has proposed a capital of Rs 20,000 crore for the DFI and set an ambitious lending portfolio target of Rs 5 trillion in three years. One approach to ensure the availability of long financing this time could be getting equity participation of private-sector players – the sovereign funds, insurance and pension funds – instead of debt participation. This would also ease the burden on the government to infuse capital in the DFI every year.

 
“First, create a DFI but run it as a private-sector entity, like ICICI. Second, let long investors come in as equity partners, not debt partners. Create some instruments so that they can participate through equity. Only then will they own the assets. There might be overseas sovereign funds and pension funds that would be interested. This might ensure a continuous fund flow,” Parekh added.
 
The lack of a vibrant corporate bond market has often been cited as a hindrance to long-term funding. Infrastructure companies, often not rated very highly, were unable to tap this market earlier. “Corporate bond market is typically a market for highly-rated corporate bonds. So, if you are not rated highly, say AAA or AA, you will not be able to raise funds,” explained CARE Ratings Chief Economist Madan Sabnavis.
 
“If we are talking of infrastructure and a DFI, it will never get an AA or AAA rating – for the simple reason that even as the money is borrowed today, the projects come up after four-five years. So, most infrastructure companies get a lower rating of BBB or A. These units, therefore, cannot meet the requirement of infrastructure funding in the corporate bond market,” Sabnavis added.

 
At present, inadequate liquidity in the secondary bond market is an issue, except for the top-rated bonds. As a result, investors cannot buy or sell corporate bonds freely.
 
To enhance secondary market liquidity and to boost confidence among corporate bond market participants, the Union Budget has proposed the creation of a permanent institutional framework. The proposed body would purchase investment-grade debt securities, both in stressed and normal times, and help develop the bond market.
 
The history of DFIs
 
The concept of DFIs took shape after World War-II, with the Germans realising the need to rebuild their nation. It was felt that a special kind of bank would be needed for infrastructure and long-term assets. The concept gained more ground in the four decades after 1945.
 
The need for infrastructure financing was felt in post-Independence India, too. The assets that DFIs normally possessed were quite distinctive from those of commercial banks. While banks dealt in working-capital loans, the role of DFIs was not that. Another issue that the erstwhile DFIs faced was a deterioration in asset quality, thanks to a combination of the risk-appraisal mechanism and external factors like labour activism.

 
Commercial banks like ICICI Bank and Axis Bank burnt their fingers when they entered infrastructure financing. They did not have the bandwidth for loan appraisal. For instance, the successful operation of, say, a thermal power plant, would depend on coal-supply linkages, an aspect many commercial banks missed. When the supply of coal would be disrupted, the entire project would become unviable, worsening the bank’s asset quality.
 
IIFCL’s Kohli said: “The loan-appraisal machinery should be very strong. And, there should be risk management. What will be the risks? How we are going to mitigate them?”
 
Another key reason for the worsening of asset quality in the 1980s and ’90s was labour activism, which made land acquisition a challenging task. There would be times when 80 per cent of road construction would be completed, but the last mile would get stuck. So, on the one hand the quality of assets was suffering, and on the other long-term financing was becoming scarce. This was the time when these DFIs were converted into commercial banks.

 
Budget vision for growth
 
The Budget has made clear the government’s intention to push growth. And the thrust on capital expenditure is an indication of its resolve to build infrastructure. The setting up of a DFI should be seen in this light. While the intentions are in the right direction, the proof of the pudding here would lie in proper governance and running the entity professionally – the two aspects crucial to the success of the DFI.
 
The government also seems to have realised the need to run the DFI professionally. Finance Minister Nirmala Sitharaman said while announcing the proposal that infrastructure needed long-term debt financing and that a professionally-managed DFI was necessary to act as a “provider, enabler and catalyst” for infrastructure financing.