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What are DFIs? How Will They Bridge Gaps in Infrastructure Sector Lending

Editor, TRANSFIN
Feb 9, 2021 12:14 PM 5 min read
Editorial

In her Budget Speech, the Finance Minister announced plans to establish a Development Finance Institution (DFI) within the next three to four months to target “mobilisation of funds amounting to ₹111Lcr ($151.3bn)” required to finance the development of various infrastructural projects in the country.

The goal is to create an institution which will act as a "catalyst and would fund projects in fields where others are not willing to enter because of the risks involved." 

What are these untrodden and risky fields being talked about? And how is a DFI going to act as the sentinel in areas where others won't? And is this really a debut move or simply a case of old wine in a new bottle? 

Let's find out!

The Story of DFIs in India 

Firstly, DFIs are not a new thing. 

The first DFI to be set up in India was the Industrial Finance Corporation of India (IFCI) way back in 1948. It was a furtherance of the Government's strategy at that time to offer long-term project financing for the industrial and infrastructural sector (kept separate from scheduled commercial banks who would instead focus on working capital and “collateral based borrowing). The idea was that scheduled commercial banks raised funds through short-term deposits and were hence not equipped to take long-term credit risk which was inherent in infrastructure and industry. 

IFCI was followed by the Industrial Credit and Investment Corporation of India (ICICI) in 1955 and the Industrial Development Bank of India (IDBI) in 1964. The period thereafter (from 1964 to mid-1990s) witnessed the growing role of DFIs in the country. Between 1993 and 1994, the amount of funds disbursed by DFIs in India rose to almost 15.2% of the Gross Capital Formation. 

Unfortunately, after this period, the role of DFIs as exclusive providers of development finance gradually began to diminish. Both ICICI and IDBI transformed into banks in the early 2000s, with the RBI's policy announcement on the "Approach to Universal Banking" in 2001.

This policy worked under the idea that under the 21st Century financial and regulatory dynamism, the lending eligibility and reach of banks shouldn't be curtailed. 

Indian financial landscape was believed to have "come of age" and operating diversification riding high on the potion of a liberalised economy and on the backs of supposedly robust capital markets was adopted as the order of the day. 

Result: Death of DFIs. 

 

Factors Leading to the Death 

Many schools of thought. 

One, the liberalisation of 1990s debunked the exclusivity of DFIs as the sole issuer of low-cost funds as people began relying more and more on the ability of commercial banks to service even the long-term capital needs of the economy. Retail deposits formed acted as the tie-breaker. 

Two, DFIs were increasingly burdened with large NPAs due to the entirety of their portfolio comprising long-term high risk project finance. Projects of this kind have long gestation making them more vulnerable to default and bankruptcy, ultimately questioning the viability of the business model adopted by DFIs. 

Three, the rise of elitism. It was alleged that the DFIs had grown too territorial with respect to their beneficiaries. Larger industrial groups were being preferred as compared to new and small entrepreneurs, resulting in a bureaucratic hegemony which was at odds with their founding objectives.

Four, the sovereign dependency of DFIs put them at the mercy of the sitting Government's political aspirations. Support from the Government has a social cost so after a cost-benefit analysis, if the Government decides to chuck a particular DFI because its mandate no longer matches the Government's electoral obligation, there's nothing one can do about it. 

As a result, in 1991, the Narasimham Committee Report recommended that apart from the integral DFIs, the rest must convert to either a bank or an NBFC. No DFI should also be established in the future without the Central Government support.

 

The Transformed Regime 

As it turns out, developmental financing jumped right out of the DFI pan into the smoldering fire of banking agility in India. The banks have traditionally relied on the safety and diligence in their investments as opposed to blasting the developmental bugle of the Government. Naturally, reluctant at the idea of lending to single operations over longer terms and faced with the possibility of non-recovery and illiquidity, to eventually bail on the assigned task. 

Even worse, the borrowers of the projects the banks lent to were often pressured with expedited timelines and forced to artificially reduce completion windows at the cost of viability. 

RBI stepped in, as it always does. A Flexible Financing Schemes (popularly called the 5:25 scheme) was started in July 2014, enabling banks to extend their lending windows up to 20-25 years to match the cash flows of projects, and refinance periodically thereafter. However, that proved insufficient in light of the scenario of increasing bad loans, stressed assets crisis and lack of skills to materialise upon these targets. 

 

Behind the Renewed Government Support Now 

The Budget has proposed a statutory sanction to the DFI with an Act of the Parliament to that effect. In addition, plans are afoot to guarantee an initial paid-up capital of ₹10,000cr ($1.3bn) from the Infrastructure Finance Company (IIFCL) with a lowered capital adequacy ratio (9% compared to 12-15% for NBFCs) for the new DFI, which is reportedly to be named as the National Bank for Financing Infrastructure and Development (NaBFID). 

Why the renewed support? One would assume that on an immediate basis, the havoc wreaked by the pandemic is making the Government grasp at any straws necessary to re-instrumentalise liquidity in the development market. Access to low-cost funds from a priority-sector shortfall is expected to be made easier. All outstanding NPAs for the new institution will be cleared. There are also talks of having a separate section in the NaBFID Bill to establish a private-sector DFI. 

But is it going to be easy? Think not!

 

Challenges to the Workability of DFIs 

If you hope to provide low-cost long-term credit, you better ensure a low-cost long-tailed source of funding. One of these sources is through the issuance of bonds. But the bond market in India is yet to become deep and liquid enough for infrastructure financing. 

Already banks face a maturity (asset-liability) mismatch while borrowing short from depositors with a maximum tenure of 10 years for fixed deposits. Therefore, they can't offer medium- and long-term loans for projects that need more than 20 years of funding. For decades DFIs could access the low-cost National Industrial Credit Long Term Operations Fund, comprising RBI’s profits and had access to bonds with Government guarantees...is that back on the table? There’s noise around “demand for grants” from the Government, but what does that mean? If pension funds and SWFs are expected to contribute, what are their incentives? 

In any case, when life gives you a pandemic, make lemonade by plucking on the huge potential of DFIs. They can contribute big in steering sectoral policy implementation with substantial importance like food security, climate change, urbanisation etc. Setting up DFIs is the easy part. Governing them and facilitating their lending functions is going to rise up to its task once it commences operations. 

FIN.

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