Launching a new class of banks won’t help

Tackle long-term finance issues before going for ‘wholesale and long-term finance’ banks



Long-term finance, especially for public infrastructure, has been crying for attention for a long time and the RBI’s discussion paper on the scope for setting up wholesale and long-term finance banks has come not a day too soon.

But the RBI seems to view the problem of long-term finance as structural, given its keenness to extend the differentiated bank model to address the gap.

This would be ironical, considering that erstwhile long-term finance institutions had converted themselves into retail banks, one even as recent as 2015.

There is nothing in the paper that supports the RBI’s optimism that a new class of banks would succeed, though this is one of the questions the central bank itself poses.

The rationale for long-term finance is clear. There is a huge and growing need for infrastructure investment with a funding gap of around ₹5,000 billion, of which government budget supports about 45 per cent while the banking sector meets around 24 per cent, leaving a large unmet gap.

With banks saddled with large NPAs from infrastructure financing, their share is bound to drop further, increasing the funding gap and hence the urgency in the matter.

Key issues remain

The reasons for commercial banks being unable to meet the ‘scale and sophistication’ of long-term assets of large corporates and public infrastructure are straightforward.

First, such financing entails running a huge asset-liability mismatch, given their average liability profile of less than two years. Long-term assets are characterised by high initial capital costs, long gestation periods, low upfront profitability — all of which require deep financing terms (10 years and above) and extended holiday periods before the projects can generate cash flows. Also, the stringent income recognition and provisioning norms act as deterrents, leaving the loans vulnerable to becoming NPAs, as did actually happen — infrastructure accounts for over 24 per cent of stressed assets and 13 per cent of total NPAs.

Secondly, long-term financing calls for specialised skills and risk taking capabilities, which used to be in the domain of financial institutions such as ICICI, IDBI and IFCI, before commercial banks became saddled with this role after these institutions began exiting from the space in the late 90s.

It is more important to address the key issues that plague long-term financing before designing a new class of banks. From the supply side, the problem of long-term finance can be simply stated as that of financing illiquid assets with liquid liabilities, an inherently unstable model.

In an earlier era, the supply of long-term funds came from pre-emption of bank deposits (through SLR bonds) borrowings from the RBI and also bilateral/multilateral borrowings.

But the wave of economic reforms in the nineties dried up these sources. Today, the only institutions with long-term funds are insurance companies and pension funds, but they face the same constraints with funds pre-empted for Central and State government borrowing.

International experience

Given the nature of wholesale assets and infrastructure, and with large corporates and Governments the primary borrowers, it may be best to let debt markets do the job, as in the case of developed economies.

It is surprising that the reference to international experience in the paper misses the role of markets, especially municipal bonds in the US. Admittedly, we have had only limited success here. But rather than building institutions, we could get banks, insurance companies and pension funds to become active enablers and players in the market, which would deepen and broaden the markets and enable maturity transformation more effectively.

Foreign capital and sovereign funds could also be good sources, but they would primarily look to the viability of infrastructure investments, which is the demand side of the problem.

Wide range of risks

Long-term assets, especially infrastructure, are a challenging asset class for both lenders and investors, given the wide range of risks that characterise them.

Political risk, for instance, makes projects highly sensitive to tariffs (tolls, power charges and telecom tariffs) that can hugely impact project cash flows.

This has been the bane of the PPP model, which relies greatly on debt financing.

Not surprisingly, three infrastructure sectors, namely power, roads and telecom, together accounted for 90 per cent of restructured assets of banks. The challenge here is to design mechanisms that make projects attractive for investors, but this would, in turn, call for a host of sectoral reforms, not an easy task in the present populist circumstances.

Unless investors find projects worthwhile, setting up new financing agencies would not help. In fact, the viability of the sector would be even more crucial to lenders, especially since the RBI is hoping to attract private promoters to this space.

The writer is an Independent consultant

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