Making DFIs work

The government’s latest Budget proposes to set up a Development Finance Institution soon to fund the ambitious national infrastructure pipeline.

“Infrastructure needs long-term debt financing. A professionally managed Development Financial Institution is necessary to act as a provider, enabler and catalyst for infrastructure financing,” the Finance Minister had said in her Budget speech.

Finally, wisdom has dawned on the government machinery to understand the importance of development financial institutions and how callous we were in allowing Industrial Credit and Investment Corporation of India (ICICI) and Industrial Development Bank of India (IDBI) to exit from the scene.

Long-term resources

These development financial institutions mobilised long-term funds for industry. Commercials banks, which could not mobilise long-term funds, could take refinance from institutions like IDBI for their long-term lending. It was not a prudent decision to wind up these two institutions and demerge with the banks sponsored by them.

Long-term financing by banks should be conducted only by mobilising long-term resources. Financing long-term projects with short-term funds is one of the major reasons for the stress in our financial system.

The residual maturity profile of deposit of commercial banks, as on March 2020, show how precariously the banks are placed with short-term funds. The percentage of deposits maturing are as follows: 29.32 per cent (less than 91 days), 16.04 per cent (91 days up to 6 months), 27.44 per cent (6 months up to one year), 19.51 per cent (1 year up to 3 years), 3.16 per cent (3 years up to 5 years) and 4.52 per cent (above 5 years). (Source: Basic Statistical Return by RBI Table No.3.4 March 2020).

Commercial banks funding long-term projects with short-term funds leads to huge asset-liability mismatch.

Apart from availability of funds, pricing the loan asset will be another problem when long-term finance is done with short-term sources. When one is not certain about the future price of deposits, it will be risky to decide long-term loan interest upfront. Making the long-term loan under floating rate interest will make it unviable for the industries as their project cost will be uncertain.

Hence, it is a sensible decision to float a development financial institution for undertaking long term financing of industries.

However, care should be taken to mobilise the necessary quantum of capital plus long-term funding for the proposed development institution. Investors will also need tax incentives.

The proposed development bank may be allowed to issue bonds with government guarantee and the bonds may be declared as eligible investment for Statutory Liquidity Ratio of banks.

Investment in such bonds can be made eligible for investment under Section 80C of Income Tax Act. Similarly, investment in such bonds can be exempted from capital gains under Section 54EC of Income Tax Act. These steps may help attract investment in the proposed development institution.

Apart from direct financing to industry, suitable refinance to banks can also be extended, so that banks will be able to undertake working capital finance. Right from the beginning steps should be taken to ensure that the financing is done with proper assessment of the project to avoid any non-performing asset in future.

The writer is a retired banker