DFI Model for Infrastructure Financing- Need, Challenges, Way Forward

DFI Model for Infrastructure Financing UPSC Essay Notes Mindmap

In the Union Budget 2021-22, the Finance Minister proposed the revival of the DFI model to meet the needs of infrastructure financing. The government has set a target of 5 lakh crore INR loan within 3 years. For this, the proposed DFI is to be capitalized with 20,000 crore INR. Given the importance of infrastructure development in the post-COVID world, there is a need to examine the viability of the DFI model and how it can be made to work in India.

DFI Model for Infrastructure Financing

What is a DFI?

  • Development Finance Institute (DFI) is defined by the World Bank as a bank or a financial institute with a minimum of 30% state-owned equity and has a legal mandate to achieve socio-economic goals in a particular sector.
  • DFI is also referred to as a development bank.
  • DFIs are meant for addressing the financing needs of development projects that find it difficult to get financing from the traditional banks.
  • These institutions provide financing on concessional terms through structured loans, guarantees, credit enhancements, technical assistance grants and equity.
  • These institutions do not take deposits. This is because taking deposits would require the DFIs to hold capital to pay pack the depositors on demand. In addition to this there is a possibility for an NPA issue when long gestation projects are involved. These could impede the DFIs’ ability to finance such development projects.
  • Instead, the DFIs raise money by borrowing from the governments through bonds.
  • Some of the areas for which DFIs are created include agriculture, trade, transport, industries and basic infrastructure.

What are some examples in India?

  • Previously, India had experimented with the DFI model in the pre-economic liberalization era when the projects for industrial and rural development– two priority areas for the government- failed to get sufficient loans.
  • The DFIs, as a new class of financial institutions, were established in the 1950s. These were set up to address the finance requirements of the industrial sector.

First Generation DFIs:

  • The very first DFI in India was the IFCI (Industrial Finance Corporation of India) which was established in 1948.
  • Following the passage of the State Finance Corporations Act of 1951, SFCs (state finance corporations) were established at the state level.
  • During this early phase of planned economic development in India, several other DFIs were are set up:
  1. ICICI Ltd or Industrial Credit and Investment Corporation of India was established in 1955 as a joint venture between the World Bank and Indian public sector banks and insurance companies.
  2. Industrial Development Bank of India Ltd was established in 1964 and it aided the development of multiple green field, modernization, expansion and diversification projects.

Second Generation DFIs

  • These were set up after 1974 as sector-specific financial institutions.
  • Some of the examples include:
  1. NABARD (National Bank for Agriculture and Rural Development)
  2. Export Import Bank of India
  3. Power Finance Corporation Ltd.
  4. Indian Railway Finance Corporation Ltd.
  5. National Housing Bank

Most probable and repeated topics of upsc prelims

How have these institutions fared?

  • In the pre-1991 period, the DFIs found it easier to lend because of the controlled nature of the economy and the protection enjoyed by the industries.
  • These DFIs’ business model was fairly uncomplicated:

 On the liability side:

  1. They could raise long term but low cost resources via various regulatory dispensations.
  2. They received subsidized credit from the government and multilateral and bilateral agencies (as they had government guarantees).
  3. They also received concessional financing from the RBI.
  4. The banks to lent to the DFIs as their bonds counted as SLR investments (statutory liquidity ratio).

On the lending side:

  1. The protected nature of the industries didn’t put the financier’s money at much risk.

 

  • However, post-1991 when the financial sector reforms were carried out, the DFIs faced competition in the market to raise liability funds. This is because the supply of subsidized credit was gradually cut off. The DFIs had to borrow from the market to compensate.
  • After 1995, the SLR status for their bonds was withdrawn which added to their difficulties in staying relevant and competitive.
  • They lost access to cheap funds but continued to lend at very low interest rates.
  • Asset-liability mismatch was a major challenge for the DFIs.
  • Apart from this, the industries became more competitive and started raising funds from alternate sources.
  • All this led to the collapse of the DFI model.
  • Multiple committees were constituted to look into the problem. They found structural problems in the model and recommended their conversion into banks or NBFCs. This would enable them to raise capital from deposits instead of from the government.
  • In accordance with these recommendations, multiple DFIs like IDBI and ICICI were converted into universal banks. Universal banks are banks that provide a variety of financial services like retail, wholesale and investment banking services under a single roof.

Why is it needed in the infrastructure sector?

  • The collapse of the DFI concept in India led to the creation of a vacuum in the development financing space in general and infrastructure financing in particular.
  • Since then, the government has been trying to let banks and other financial institutions fill in the role of DFIs and fund infrastructure project.
  • An example for the use of this strategy is the policy that started in 2009-10. The strategy ran into trouble very quickly (in 2011-12 itself).
  • There are various issues in using the traditional banks for infrastructure funding:
  1. Maturity mismatchlong gestational period of infrastructure projects accompanied by numerous delays (land acquisitions, litigations, etc.) affects the banks’ balance sheets and adds to their NPA burden.
  2. Lack of appraisal skills among bankers.
  3. Asset liability mismatch
  4. Inability to provide adequate low cost funds, etc.
  • The government had tried to recapitalize the banks to aid them in this role. In addition to this, the RBI had introduced restructuring schemes. But these measures weren’t successful.
  • As of March 2020, the total outstanding loans to infrastructure sector stood at 54 lakh crore INR. The current economic situation, brought in by the pandemic, could potentially increase the NPA burden in the banking sector. Hence the banks and NBFCs are not in a position to provide sufficient funds for infrastructural development.
  • This is despite steps from the RBI like according special status to the sector and revising the NPA recognition norm from 90 days to 180 days.
  • In addition to this, infrastructure projects are associated with uncertainties and the loan repayment is greatly dependent on its cash flow– more than on the realisability of collaterals.
  • In its 2019-20 annual report, the RBI suggested the reduction of excessive dependence on the banking system for infrastructure financing.
  • The economy had come to a standstill because of the pandemic. Infrastructure development is vital to kick start the growth cycle as it has strong linkages– both forward and backward.
  • Both soft and hard infrastructure facilities tend to have a multiplier effect on the economy.
  • Also, as the government seeks to establish India as a manufacturing hub, it is essential to put in place world class infrastructure facilities.
  • Infrastructure is categorized as a public good, hence nurturing DFIs is a part of the nation building exercise.

What are the challenges?

  • A major reason why the earlier DFIs failed was due to high cost of funds and an absence of a well-oiled monitoring mechanism for the projects’ implementation.
  • As seen from our previous experiments with DFIs, lack of sustained fund flow could prove to be a major constraint for the proposed DFI. However, providing DFIs with subsidized credit isn’t a sustainable solution in the long term.
  • Use of short-term deposits cannot be a long term solution either. This would add to the NPA crisis of the banking sector.
  • Over the years, reforms were carried out with respect to equity market. However, the debt market in India continues to have a weak foundation.
  • DFIs, to succeed as a model and become sustainable, need to mitigate a number of risks like market risks, interest rate risks, exchange rate risks, This is especially because DFIs have to fund long gestation projects that go on for decades.
  • Lack of corporate governance could couple with mis-management of liabilities and assets could lead to major failures. Eg: IL&FS case is one of the recent cases.
  • Knowledge, experience, skill and wisdom are major determinants in banking. Senior credit officers in the sector, who possess the necessary experience, retire over time. In other cases, officers overlook the lessons from past episodes of bust. All these result in loss of learning and experience and consequently lead to deterioration in institutional memory.

What is the way forward?

  • To address the subsidized credit issue, the bond market must be developed. A well-developed bond market will help the DFIs raise capital and on-lend to infrastructure projects.
  • For this, the faults in the current bond market must be addressed. Fragmentation– with a government bond market on one side and a corporate bond market on the other- a major defect. Elsewhere, successful bond markets have an integrated structure.
  • Currently, there is an absence of well developed, liquid government bond market and the corporate bond market suffers limited liquidity in the category of bonds with lower rating. The Indian bond market is dominated by private bond placements which are simply held to maturity.
  • Hence the bond market can also do with regulatory and infrastructure changes. These have been on the agenda of the government and the RBI for long now.
  • To encourage the development of the corporate bond market, the government can provide tax incentives on the income tax and capital gains front for investors.
  • The RBI could consider opening repo window for utilization of forex reserves for DFI’s infrastructure financing activities. This can be based on the DFI’s natural hedging position and asset books.
  • The growth in pension and insurance sector could partly address the issues faced by the DFIs in raising long term liabilities. To make full use of this potential, the regulatory restrictions impeding the insurance and pension funds from participating in infrastructure financing, could be eased.
  • The proposed DFI must be established as a professionally managed entity with low scope for political interference.
  • For this, the government could use a ‘holding company structure’ and invite private equity participation to bring in capital, professionalism and technical expertise for the DFI.
  • Eventually, the DFI could be listed through an IPO (initial public offering) to enable corporate governance of the DFI that is monitored by the market forces and adequately supervised by the regulator.
  • Use of ‘fit and proper’ criteria for appointment of the board of directors by the holding company. For this, the board of banks or financial institutions need operational freedom.
  • To address the challenges of human resource gaps and staff attrition (reduction in workforce), there is a need for a continuous recruitment process, experience-based training and capacity building of personnel in areas like risk management, credit appraisal and loan recovery.
  • Project assessments must be done by DFI personnel equipped with project finance skills, technical knowledge and professional expertise in the infrastructure sector. This is because assessment of projects is different from assessment of working capital requirements.
  • The setting up of a DFI from the government’s side needs to be complemented with DFIs from the private sector. For these private DFIs to work, a differentiated business model is required (as conventional long-term lending model may not work for infrastructure financing).
  • With regards to the DFI’s functioning, the high level of cash flow mismatch and low rating of the infrastructure companies in its initial years can be addressed through provision of a credit enhancement or ‘first loss’ support for a fee by the DFI. This can be used as backing for the commercial banks to fund their projects. It will also help the DFI earn a fee income, making the model viable.
  • The risk can be syndicated with other DFIs. The DFIs can further reduce the risk by getting an insurance cover against the pooled credit enhanced assets.
  • Once the infrastructure project starts generating cash flow, such credit enhancements may not be required, as the credit rating would have improved. In this stage, the project can receive financing by issuing bonds in the capital market.
  • Establishment of an apex body to address policy paralysis and avoid costly delays by facilitating land acquisitions and statutory clearances for infrastructure projects in a timely manner.

Conclusion

Infrastructural development is vital, not only for kickstarting the economy, but also for reshaping India as a manufacturing hub. However, development financing is risk-ridden and the use of banking sector for this purpose is non-viable. The successful execution of the government backed DFI with adequate operational independence may bring back the confidence in the DFI model. But regulatory and infrastructural changes in the bond market must precede the creation of the DFI. This will pave way for the private sector’s entry into the DFI arena. Private sector DFIs for infrastructure financing can succeed with a well-functioning business model of partial credit guarantee scheme.

Practice question for mains

‘DFI model is sine qua non for realizing India’s dream of becoming a $5-trillion economy by 2025.’ Discuss. (250 words)

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