Its success will hinge on, among others, the cost of raising funds, returns for investors and efficient project appraisal
The creation of a new DFI (development finance institution) is now real with the government starting the process with zest. It is still not certain whether it will be a new institution or whether it will involve merging an existing institution. The government will put in ₹20,000 crore of capital and the DFI will be able to raise and finance projects over ₹3 lakh crore. The idea is great.
Now let us put the concept in perspective. There were DFIs in the past which chose to get converted to universal banks, which simply meant that they became commercial banks through reverse mergers with their existing commercial banks. This was not because commercial banking was more attractive but on account of the DFI model not being sustainable.
DFIs used to get concessional finance from government and multilateral institutions, which was used for term finance. This helped create assets in the manufacturing and infrastructure space. But the concession window ceased to operate following the reforms of 1992. The DFIs from then on had to borrow from the market and pay, at times, even around15 per cent for funds; therefore, the cost for the borrower had to be higher.
A decision was hence taken that they become commercial banks where the cost of funds those days was less than 10 per cent as demand deposits (share of 10 per cent in deposits) came free, savings deposits with share of 25 per cent came at 4 per cent and the term deposit costs varied with the interest rate environment.
Now it is a time to roll back the clock and have a DFI created by the government to begin with, which can gradually be divested to 26 per cent level at the appropriate time. This may sound a bit antithetical to the view taken, at the same time, on privatising two public sector banks (PSBs) on grounds of the government not having the right to be in business. The only explanation is that the private sector is not in a position to invest such an amount for infra funding and hence the government has to step in. A bit of déjà vu here because even nationalisation was based on a similar sentiment.
The government has assured that the DFI will be run by professionals which should be comforting, as all decisions would be based on commercial judgment. It would be interesting to see if the Banks Board Bureau (BBB) would be involved again with the appointments, in which case it could mean facing the same challenges which came in the way of selection of bank personnel. BBB has members appointed by the government who then select the management personnel of public sector banks. But this will probably be a secondary issue given that there’s need for such an institution and the government is taking a giant step by putting in ₹20,000 crore.
Where will the leverage come from? Will private investors be willing to put in money in a new DFI which is owned by the government? It will depend on the kind of return that can be earned. As the borrowers will be in infra which will be able to start earning money to repay debt with a lag of 3-4 years, the waiting period will be long. Are investors willing to wait?
Also, can the DFI give a return of, say, 10 per cent on capital? These ballpark numbers are important because there are alternative investment opportunities for financial investors which yield quick returns. Foreign investors will find comfort in government ownership but have to get the confidence of getting a return after a lag before putting in money. Else, it may end up as being an institution which gets its funding from other public sector financial institutions which the government is looking to privatise or disinvest. This will create some ideological challenges when getting funding for a new DFI.
The other issue is cost of raising funds. In the absence of tax incentives interest on bonds issued by the DFI will find few takers. Tax-free bonds have been used successfully in the past and should be offered again to get household savings into the fold. Ideally, an interest rate of 7-8 per cent would be attractive enough. Anything lower would be unfavourable for investors as debt funds typically give 7-9 per cent with capital gains tax rate of 10 per cent without indexation.
Should banks be allowed to participate in any way? Ideally no, as the DFI has to create a model which runs without the support of banks as it will be doing what banks are not able to do in an efficient manner. Allowing SLR status to these bonds will make banks subscribe to these safe bonds.
Contours of DFI
The business-related issues that have to agreed upon are the contours of the DFI. First, the DFI should do direct lending for projects which will require the creation of an expansive pool of professionals at all levels. Project appraisal of infra projects requires a different mindset. Second, the business of refinance should also be part of the mandate and here the decision has to be taken on the composition of the portfolio between direct finance and refinance. It should not be one which does only refinance, which is what some of the other institutions did when they were set up to finance infrastructure.
Third, the DFI should be in a position to provide enhancements for loans given by other institutions which will be in the form of a contingent liability. Here too limits should be put on the risk that can be taken as such guarantees or enhancements improve the credit rating of the borrowing entity.
Fourth, the DFI can also take on the role of a market maker in the bond market as part of its treasury operations which will be required to address mismatches in maturity and returns. It can take a lead role in the development of the CDS (credit default swap) market.
Therefore, exciting times are ahead with the formation of the new DFI, which should provide much-needed boost to funding infrastructure.
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