Not just another development financial institution

Krishnan Sitaraman | Updated on: Jul 04, 2022
Krishnan Sitaraman, Senior Director and Deputy Chief Ratings Officer, CRISIL Ratings Ltd

Krishnan Sitaraman, Senior Director and Deputy Chief Ratings Officer, CRISIL Ratings Ltd

It is imperative for the new DFI to have a strong risk management architecture to avoid asset-quality challenges of the past

The government’s National Infrastructure Pipeline (NIP) of 7,400 projects, with a cumulative cost of ₹111-lakh crore, will require a regular flow of long-term credit at reasonable rates.

A government-promoted development financial institution (DFI), which has recently been set up, with an initial capital of ₹20,000 crore and a target of ₹5-lakh crore of project funding over next three years, is seen as a step in this direction.

But India has had DFIs in the past as well, set up with a similar objective. They, however, over time suffered from asset-liability maturity (ALM) mismatches, and lacked stable and sustainable sources of long-term funding, adequate credit appraisal and risk management systems. This led to high non-performing assets and, in the absence of effective stress resolution mechanisms, to low recoveries, which eventually compelled some of these to convert to commercial banks.

Valuable lessons learnt

Globally, too, a number of countries have tried setting up and scaling up national DFIs to catalyse funding to specific segments; they have met with mixed success. Their experience also offers valuable lessons for the new DFI. To be sure, the new DFI will operate in a macro and regulatory environment, very different from the past. For instance, resolution mechanisms for stressed assets, particularly with the implementation of the Insolvency and Bankruptcy Code, are more robust; and market innovations have taken place in the area of refinancing of operational infrastructure assets such as infrastructure investment trusts and infrastructure debt funds.

But this may not be enough to ensure success. As the experience of other countries’ DFIs shows, for successfully sustaining and scaling up of DFIs, three more vital ingredients must fall into place: a supportive ecosystem on the funding side, a sustainable business model with income diversity, and robust credit appraisal and risk management systems.

Getting the mix right

Having resilient sources of funding on both debt and equity sides, with an optimal mix of public and private sources, will lead to the development of a strong liabilities profile for the DFI. The government ensuring regular availability of capital, akin to the support provided to public sector banks, will ensure that leverage levels are under control. With an ambitious ₹5-lakh crore funding target, the government infusing more capital over time or bringing in strategic investors will be supportive.

Even in case of a dilution in government shareholding, continued sovereign support can ensure funding access from the debt capital markets (both domestic and international) at competitive rates. This will enhance comfort to lenders and debt investors which will help the DFI build up an optimal funding profile from the perspective of both access and cost.

There are multiple ways in which sovereign support was provided to DFIs in the past. These include classifying bonds issued by DFIs as approved investments under statutory liquidity ratio of banks, providing access to direct funding from the Reserve Bank of India, the government providing sovereign guarantee on the DFI’s bonds and also giving tax breaks to investors in these bonds. A combination of the various manners of providing support outlined above, can enable the DFI to raise private funding at favourable terms.

Besides, issuance of long-dated debt, in excess of 15-year maturity, would help the DFI address ALM management challenges that, given the current state of Indian bond markets, may not be easy without sovereign support.

Hybrid revenue streams

In addition to lending to infrastructure projects, diversity in income streams and partnerships can be beneficial from a sustainability perspective for a DFI. Globally, DFIs have worked to develop a range of instruments, including syndicated loans, partial credit guarantees and credit enhancements.

In the Indian context, too, supplementing the traditional lending business, with products such as credit enhancements to infrastructure debt, will provide an alternative income stream. These could include providing first loss guarantee to infrastructure projects, especially in the initial years as well as guaranteeing some of the bonds raised by infrastructure projects. That could lift the ratings of these projects and aid in channelling funds from long-term investors such as insurance companies and pension funds.

A mix of fund-based and non-fund-based businesses can help the new DFI play multiple roles in supporting the funding needs of infrastructure projects. It could catalyse funding from other lenders and investors as well (crowding in of private funding), thereby lowering its borrowing requirements.

Such a ‘hybrid’ business model can help diversify and stabilise the DFI’s revenue streams and, in turn, improve its profitability.

Partnerships with other financial institutions and banks in case of large loans to diversify the risk or churning the portfolio through securitisation as projects reach completion to release capital and on-lending to new projects are other potential ways to solidify the business model. For the new DFI, it is imperative to have a strong risk management architecture in place, to avoid the asset-quality challenges seen in the past. A mix of robust credit appraisal processes, appropriate early warning mechanisms, strong surveillance processes and solid recovery infrastructure will be key to keep credit costs low.

The asset base of the DFI will also benefit from being diversified across different geographies and sectors, which can help avoid concentration risks and protect against the cyclical nature of some of the infrastructure sub-sectors. Along with effective risk management systems, a robust risk-pricing mechanism will also be important to ensure adequate risk adjusted returns. Following independent policies and adequately factoring in the risks/rating while lending to a project will help minimise asset quality challenges.

Transparent operations

One must not also underestimate the role of the governance framework in the growth and success of the new DFI. As seen globally, professional management with transparent operations are key to instilling confidence in different categories of stakeholders.

An overall improvement in the landscape for infrastructure projects and addressing environment, policy and regulatory delays that can lead to time and cost overruns for projects, will also go a long way in providing a supportive landscape for the new DFI.

Krishnan Sitaraman is Senior Director and Deputy Chief Ratings Officer, CRISIL Ratings Limited

Published on July 04, 2022
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