Tuesday, April 18, 2017

Do we need term finance institutions?

We shut down two of three term finance institutions we had in the early 2000s, ICICI and IDBI, getting both converted into banks. IFCI changed into an NBFC later. Now, in a discussion paper, the RBI moots the idea of creating term finance institutions. Many, including former RBI Governor C Rangarajan, have long argued that closing down term finance institutions was a mistake and that we need to revive these in order to facilitate long term financing (given that bond markets have not taken off).

I think there is  case for doing so. But, in today's conditions, only a government-owned institution with access to concessional finance will be viable. More in my BS piece, Back to term finance institutions?

As the BS article is behind a pay wall, I reproduce the article below:

The Reserve Bank of India (RBI) has issued a discussion paper that moots the idea of long-term finance banks. This would amount to seriously turning the clock back to the early 2000s. 
We then had three development financial institutions (DFIs) that focused on term finance, namely, IFCI, ICICI and IDBI. Commercial banks confined themselves mainly to providing working capital. 
There were reasons for separating the two roles. Banks’ funds are mostly short-term in nature. So their getting into term finance results in long-term assets being financed by short-term funds. This exposes banks to interest rate and liquidity risks.
Secondly, providing project finance requires appraisal skills of a different sort from those required for providing working capital. Working capital is backed by assets that are easily liquidated. Not so project finance. You have to depend on cash flows to service the debt. This makes the evaluation of risk far more challenging.  
Term-finance institutions have to rely on long-term funds. This means more expensive funding and hence costlier loans. The DFIs could get around this problem because they were given access to low-cost funds  from the RBI and through bonds guaranteed by the government and that qualified as statutory liquidity ratio (SLR) securities. 
At their peak in the late 1990s, the three DFIs accounted for nearly a third of gross fixed capital formation in manufacturing. Most of the loans were made to manufacturing. Lending to infrastructure accounted for just 15 per cent of the total. (Deepak Nayyar, <i>Economic and Political Weekly<p>, August 15, 2015).
Financial sector reforms in the mid-1990s meant that concessional funding was out. Banks were allowed to venture into long-term funding. DFIs were then reeling under the impact of bad loans of the past. These together undermined the DFI model. 
The idea that working capital and long-term finance should happen under one roof took hold. The second Narasimham committee on financial sector reforms (April 1998) and the S H Khan Working Group (May 1998) both recommended that the roles of DFIs and banks be harmonised.
The RBI was not entirely convinced. In a discussion paper published in January 1999, the RBI warned, “Drastic changes in their (DFIs’) respective roles at this stage may have serious implications for financing requirements of funds of crucial sectors of the economy.”
Nevertheless, the RBI chose to fall in line with the Narasimham committee recommendations — it is often said, under pressure from the international agencies that had provided structural adjustment loans. The RBI advised the three DFIs to convert themselves into banks or non-banking financial companies (NBFCs). ICICI and IDBI opted to merge with their banking subsidiaries. IFCI muddled along and eventually became an NBFC.
In Japan and many East Asian economies too, the role of DFIs was curtailed over time. But this happened only after certain conditions had been met: A high savings rate, large foreign direct investment (FDI) flows and considerable growth in domestic capital markets. The Indian economy had not met these conditions in the early 2000s. Doing away with DFIs at that point was thus rather premature.
The RBI discussion paper seems to acknowledge as much. It argues that, in recent years, bank lending to the services sector, industry and small and medium-sided enterprises (SMEs) has suffered thanks to the bad loans on their books. It says that banks lack the expertise necessary for term finance. There is a need for term-finance institutions to fill these gaps.    
The proposed term-finance institutions would have a minimum capital requirement of ~1,000 crore, higher than the ~500 crore stipulated for commercial banks. They cannot have savings accounts but they can have current accounts and term deposits with a minimum of, say, ~10 crore. They would be exempt from cash reserve ratio (CRR) requirement for funds raised through infrastructure bonds. These funds would also need to be exempted from SLR requirements in line the relaxation given to commercial banks. 
The key question, which the paper sidesteps, is: How do we ensure viability?
If the proposed term-finance institutions are to raise finance entirely from the markets, it will make their loans far too expensive. Banks may be leery today of financing projects at the outset. However, once a project is close to completion, they are happy to refinance loans at lower rates. This is happening with power projects, for instance. Term-finance institutions may not be viable as long as they face higher borrowing costs than banks. 
To be viable, they will need to access concessional funding through government-guaranteed bonds and low-cost funds from the international agencies. So, yes, there is room for a term finance institution but only one that is promoted by the government and gets subsidised funding — in effect, a new avatar of IDBI. 
Will the government have the stomach for an initiative that looks distinctly anti-reformist? Would it want to promote a new financial institution at a time when it wants to shrink the numbers of those that obtain today?

1 comment:

Anonymous said...

Dear Sir
In the 1st instant, thanks for posting yr article here as on Biz Std not possible

More things changes more they remain the same is applicable to DFIs

The agreement is that the close down of DFIs was premature

It was done in a haste to , if I can submit get over NPAs issue from whole sale banking
The logic being that the millions of retail loans preferable to 10000 loans to 1000 organizations - pull of the lower retail (better spread not to forget) NPAs and push of higher corporate /wholesale NPAs! However or rather howsoever, banking sector could not get rid of the problem wholesale NPAs- in its earlier avtar of DFIs or the new incarnation of commercial banks as commercial banks are now more deeply into corporate loans - ending up with NPAs - the very problem that they (DFIs - financial institutions /banks) were trying to get rid of !

NPAs arose due to variety of the reasons- project related issues and also ALM complusion (let us keep aside other things for the time being)
Out of the above 2 , project related issues (clearances, approvals) is beyong the pruview of financial sector leaving ALM to be tackled
So based on ALM the old arrangement is good - long term finance, good expertise in project appraisal etc
Only the source of long term finance dried up due to liberaliation and deregulation of interest rates

NPAs have remained - whether DFIs or banks - financial intermediaries

Now structure of the private sector has changes - manufacturing loans, technology sector ,loans to infra , agro , social sector and service So the revamped structure needs to understand all these strctural shifts as term (duration) , underlying asset composition, cash flow etc will vary for all the above sectors
Any concept paper should assess and factor those structural changes and not confined to only mnaufacturing and infra

DFIs- all india and state level were catalyst for creating industrial (manufacturing base) in India in the 1950s to 1990s - when capital was scarce and venture capital non existent !
The projects were if i may say only in the manufacturing and mining sector !

There is need to separate commercial /retail banking and corporate banking (especially with project requireing 3 5, 5 or long term finance) due to ALM issue

Globally DFIs are resurgent In fact you have stolen my thunder as I have been mulling over wirting this since the last 2 years and dawdling on that!

One former head of DFIs (now head of an international DFI) is trying very hard to create, nay recreate, DFIs back doors through the old ways - lending through lines of credit - a la KFW, IBRD to DFIs his old DFI now a commercial bank) for onward lending to corporates Also bond issue in India under Masalla bonds is being planned !

The issue of financing is to look at global DFIs and how they are being financed

If you recall in those days (1950s through 1990s) DFIs and commercial banks had created inverted yeild curve - long term finance @14% against short term - working capital loans at +19% The govt needs to work on corporate bond market by building mechanisms to wean the corporates from bank finance - cash credit facilities which shifts the onus of credit planning from corporates to commercial banks!

There should be some incentive for large and well established corporates to move to commerical papers (there is already due to lower rate than bank finance) and bonds and also diincentive to dssuade them from bank finance