New-age DFIs required to fund India's infrastructure

This article appeared in DNA on 15th April, 2018

India is finally grappling seriously with its large non-performing assets (NPA) problem, and the first green shoots of structural changes — recapitalisation, new bankruptcy code, and new NPA recognition norms to resolve the issue — are seemingly visible. While the new institutions, laws and regulations will learn as they are tested, there is a belief that the problem is closer to resolution than ever before in the last four years. However, this is merely rectifying the past.

An equally tricky issue, one that has received somewhat less attention is: What next? How would we fund the next investment cycle which should be taking off in the next year or two? The present NPA crisis was substantially engendered by commercial banks funding infrastructure and other long-term capital expenditure in a big way. It is unlikely that either shareholders, including the government, or the regulator (RBI) would be overly enthusiastic to have commercial banks funding long-term infrastructure again in a big way. Which begs the question, how does India fund its enormous infrastructure needs? Over the last few years, alternate modes of financing — Non-Banking Finance Companies (NBFC), Mutual Funds (MF) and Alternative Investment Funds (AIF) have grown in size and appetite to fund long-term financing requirements. However, structurally MFs and other instruments are largely open-ended vehicles with limited appetite for long-term, illiquid assets. As a result, in terms of size, they are going to be insufficient to bridge the gap that will be left by banks.

In a typically karmic twist, it would seem that the solution would lie in the resurrection of Development Finance Institutions (DFI). Till about 20 years ago, long-term capital requirements of the Indian corporate sector were met by DFIs. The raison d’être of DFI financing long-term debt capital was quite intuitive. DFIs would typically raise long-term financing via attractive tax-free bonds, making it possible to extend long-term loans without running into huge asset-liability mismatch issues. Universal Commercial Banks (UCB), on the other hand, typically raise funding via short-term deposits, and used to have very high statutory liquidity requirements in the forms of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). Consequently, it was quite unviable, both from a pricing as well as from a risk management perspective, for UCB to do large-scale long-term financing.

However, liberalisation changed the landscape completely. With reforms, came in a substantial decrease in CRR and SLR, thereby drastically reducing the cost of funding for UCB. Consequently, the pricing advantage on the cost of funds is reversed, with UCB having a large advantage over DFI. Further, liberalisation of financial markets brought in new instruments (like Interest Rate Swaps, MIFOR, etc) that participants could see developing into effective hedging tools for asset-liability mismatches (long-term loans, short-term, funding via deposits) in the foreseeable future. Liberalisation also brought around an expansion of market participants in the form of mutual funds and private sector insurance companies, both of whom were expected to broaden the market for the new instruments. Soon enough, two of the largest DFIs (ICICI and IDBI) mutated into universal commercial banks, while two others (IFCI and IRBI) withered away.

Unfortunately, as we have seen over the last few years, UCB’s foray into long-term lending has not been a happy experience. Given that most UCBs are funded to a large extent by retail deposits, it has also meant a default sovereign guarantee on the UCB, resulting in taxpayer-funded bailouts. While these are much smaller than the rest of the world, it still raises questions of fairness and accountability.

Ironically, DFIs would be an interesting solution to the problem. They could be primarily funded by wholesale customers through deposits or bonds issued to large corporates and institutions. Ergo, there would be lesser pressure on the government to intervene even if there is a viability issue that develops. Second, being focused on long-term loans, DFIs would develop unique skill-sets in assessing, underwriting and managing their risks. The RBI issued a discussion paper on wholesale and long-term finance banks last year on the viability of a similar construct. It would be tough to revert to the pre-1991 construct of DFI — the world has changed, and Indian markets have also gotten a lot more sophisticated.

The DFI, in its new avatar, could be a hybrid between a western-style investment bank and a traditional UCB. It would not only raise long-term financing to fund long-term assets, it would also be an active market participant in developing the long-term corporate bond market. Contrary to popular notions, India does not have a shallow corporate bond market compared to other peer-group economies in the developing world.

The issue is one of secondary-market liquidity, caused by a dearth of market participants in the space. The new DFI would be an active market-maker in long-term financing structures, as an intermediary as well as a source of intellectual capital. India has been actively scouting for and in some ways successfully attracting foreign investment pools like pension funds and sovereign wealth funds for infrastructure investments. However, given the magnitude of our requirements, foreign investment will always be a small complement to the domestic effort. We need institutions with long-term asset-liability horizons to fund India’s infrastructure, and re-engineered and imagined DFIs are a uniquely suitable option. It’s an idea whose time has come because without an alternative mechanism, India’s long-term financing needs will be hobbled.

“Plus ça change, plus c’est la même chose” — the more things change, the more they remain the same. The old chestnut seems amazingly prescient for India’s banking market!