We need a bank just for long-term credit

C Rangarajan S Sridhar | Updated on March 09, 2018

Dark future Without long-term lending   -  Akhilesh_Kumar

Constrained by NPAs, banks are unable to extend long-term loans. It now seems that shutting pre-reform DFIs was premature

It is now well recognised that one of the critical issues facing the economy is the stressed loan assets of the banking system. As per available data, the gross non performing loans (NPAs) of all commercial banks amounted to ₹6.5 lakh crore; that is 8.6 per cent of their aggregate loan book as at end of June 2016. The corresponding figures for the public sector banks are even more alarming. ‘Stressed’ assets i.e. NPAs plus restructured assets shown as standard in the books of the banks, stand at approximately ₹12 lakh crore i.e. 12.1 per cent of outstanding loans and advances. Some analysts have estimated total stressed assets ratio at over 16 per cent.

A fall out of the stressed assets situation is the decline in fresh lending. Bank lending to the corporate sector has contracted in absolute terms during 2016-17 by 5.2 per cent over the previous year as against a growth of 2.8 per cent in 2015-16.

The decline in credit growth has affected both short term and long term credit. This may partly explain the steep fall in corporate investment, which at the height of our high growth period stood at 14 per cent of GDP.

The debate on the NPA issue has largely focused on resolving the stock of NPAs. This is no doubt important and several proposals are under active consideration. But the fact of the decline in term-lending and the consequent impact on private investment and more particularly corporate investment has not received much attention.

Evolution of DFIs

At this juncture it will not be out of place to recount briefly the history of the evolution of industrial financing in our country. Post independence, as India embarked on an ambitious industrial development programme, the concept of development financial institutions (DFI) was embraced. The Industrial Finance Corporation of India (IFCI) was set up as a fully owned Government of India (GoI) entity in 1948, Industrial Credit and Investment Corporation of India (ICICI) was set up in 1955 in the private sector.

Industrial Development Bank of India (IDBI) was a part of RBI from its inception in 1964 until it became a separate entity owned by GoI in 1976. In addition a number of sector- specific DFIs were set up under the administrative control of other ministries.

The DFIs were envisaged to provide medium and long term credit supplementing the commercial banks who provided short term credit for working capital. DFIs grew rapidly — the combined asset base of DFIs was ₹6,143 crore in 1981, which increased to ₹52,054 crore in 1990-91 and to ₹158,379 crore in 1998-99.

The DFIs had access to cheap funds largely in the form of i) National Industrial Credit Long Term Operations (NIC-LTO) Fund, which was created out of the profits of the RBI and ii) bonds which were reckoned for computation of Statutory Liquidity Ratio (SLR) purposes for commercial banks who subscribed to these bonds.

For example in 1989-90, the share of borrowings from RBI and rupee bonds in total borrowings of IDBI was 23 per cent and 40 per cent respectively. This access to low cost funds was vital as it enabled the DFIs to lend directly or indirectly (through banks and other financial intermediaries by way of refinance) to enterprises at affordable cost i.e. the latter’s internal rate of return could then exceed the cost of capital.

As part of the banking sector reform initiated in 1991, the flow of funds from LTO ceased, reducing the availability of low cost funds to DFIs. With lower levels of pre-emption such as CRR and SLR freeing up funds for lending, it was believed that the banks would be able to provide adequate credit both long term and short term to industry. In addition, the equity and bond markets that would be widened and deepened progressively were expected to provide the needed long term finance.

Demise of DFIs

As banking reform gathered pace, role of DFIs diminished. With the loss of access to lower cost funds, lending rates of the DFIs had to be increased to a level where they were uncompetitive as compared to banks, which had rapidly expanded their term loan portfolio. Increased access to external commercial borrowings (ECB) as well as capital markets to corporates led to further decline of DFI lending. Meanwhile, RBI permitted the opening of banks by private sector or semi public sector. This resulted in term lending institutions such as IDBI and ICICI setting up commercial banks.

The long term portfolio of banks has grown. As of March 2016, medium and long term loans had touched almost 50 per cent of total loan portfolio. Apart from the liability-asset mismatch, banks are also running into various exposure limits. This has constrained the ability of banks to extend long term loans. The bond market is still to become vibrant. With the growing NPAs, the flow of long term credit has been choked and this has to some extent affected corporate investment.

It is therefore time to rewind and accept that the closing down of the DFIs was premature and allow the setting up of term lending institutions. A Long Term Credit Bank (LTCB) or by whatever name it may be called, must be set up by government to provide medium and long term credit to manufacturing and infrastructure, barring the power sector. The power sector is well served currently by DFIs such as PFC, REC, and IREDA.

Long-term credit bank

The LTCB will need to be fully or substantially owned by GOI, but should be bestowed with full operational autonomy. LTCB may finance green field and brown field projects across manufacturing, infrastructure and other areas as may be considered fit.

Three distinct advantages may be identified for the LTCB. First, it is a response to the gap that has emerged in institutional financing structure and would thus have a ready market. Second, as a specialised institution with expertise in project finance LTCB will be able to better evaluate the loan proposals. It will also be able to attract suitable talent on ongoing basis which the banks may not be able to do. Third, LTCB can assist the faster development of the corporate bond market through credit enhancement, and partial credit guarantees.

A key element in the new scheme is that LTCB must be provided with low cost resources to enable it to lend to enterprises at reasonable rates. The model will not work otherwise. The DFIs currently in operation do enjoy such an advantage albeit, in a different way such as NABARD through Rural Infrastructure Development Fund, NHB — Rural Housing Fund — both of which are funded by penalties on non-achievement of certain Priority Sector targets by banks. LTCB must be permitted to avail of ECB and assistance from multilateral and bilateral agencies such as World Bank, ADB, JICA, KFW. Thus the LTCB will have a mix of funds, some raised at the market rate and some provided at a concessional rate. The new institution should be able to raise funds from the market on its own strength.

The current situation demands not only finding a solution to the high level of NPAs in banks but also to revive long term lending to industry. The latter needs an approach different from dealing with accumulated NPAs. Sharpening focus on investment-led growth is the need of the hour. It is time to rewind and set up term lending institutions with specialist skills dedicated to financing projects in manufacturing, infrastructure, and services sectors.

Rangarajan is a former RBI Governor. Sridhar is a former CMD of Central Bank of India & National Housing Bank

Published on April 09, 2017

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