Banking Article, Banking Finance 2021, Banking Finance December 2021

DEVELOPMENT OF FINANCE INSTITUTION – The Way Forward

Finance Minister Nirmala Sithraman while presenting the Union Budget 2021-22 stated that India will set up a new Development Finance Institution (DFI) called the National Bank for Financing Infrastructure and Development (NaBFID). The institution will be set up on a capital base of Rs.20,000 crore and will have a lending target of Rs.5 lakh crore in three years. Debt financing through the infrastructure investment trust (InvIT) and real estate investment trust (REIT) routes will be enabled through necessary amendments in the rules.

Development Finance Institution describes the institution “as a provider, enabler and catalyst for infrastructure financing and as the principal financial institution and development bank for building and sustaining a supportive ecosystem across the life-cycle of infrastructure projects”. It will help to cater to the wholesale and long-term financing needs of India and possibly fill the gap in long-term financing.

What Is A Development Finance Institution?

The Development Finance Institution (DFI) are organizations which are either owned by the government or by charitable institutions to finance infrastructure projects that are of national importance but may or may not meet commercial return standards. In most cases, these agencies are government owned and their borrowings enjoy the comfort of government guarantees, which help bring down the cost of funding. The objective also includes issuance of guarantees and facilitating development of a bond and derivative market. Proposed tax breaks will enable increasing cost-effective resource raising.

Objectives of Development Finance Institutions

  • The prime objective of DFI is the economic development of the country
  • These banks provide financial as well as the technical support to various sectors
  • DFIs do not accept deposits from people
  • They raise funds by borrowing funds from governments and by selling their bonds to the general public
  • It also provides a guarantee to banks on behalf of companies and subscriptions to shares, debentures, etc.
  • Underwriting enables firms to raise funds from the public. Underwriting a financial institution guarantees to purchase a certain percentage of shares of a company that is issuing IPO if it is not subscribed by the Public.
  • They also provide technical assistance like Project Report, Viability study, and consultancy services.
  • The role of the Development Finance Institution (DFI) is to take cognizance of the gaps in institutions and markets in the country’s financial sector and to act as a gap filler. 

History of DFIs in India:

  • Development Financial Institutions provide long term credit for capital-intensive investments spread over a long period and low yielding rates of return such as urban infrastructure, mining and heavy industry and irrigation systems.
  • Development banks are different from commercial banks, which mobilize short to medium term deposits and lend for similar maturities to avoid a maturity mismatch.

DFIs have evolved in India in three below-mentioned phases:

  • The first phase began with Indian Independence to the year 1964. In India, the first DFI was operationalized in 1948 with the setting up of the Industrial Finance Corporation of India (IFCI). Subsequently, India’s Industrial Credit and Investment Corporation (ICICI) was set up with the World Bank’s backing in 1955.
  • The second phase began from 1964 to the mid-1990s. Industrial Development Bank of India (IDBI) was set up in 1964 under RBI to promote long term financing for infrastructure projects and industry and was granted autonomy in 1976. However, during the 1970-1980s, DFI got discredited for mounting non-performing assets, allegedly caused by politically motivated lending and inadequate professionalism in assessing investment projects for economic, technical and financial viability. Due to these factors, Narsimhan Committee (1991) recommending disbanding of the DFI, and the existing DFI were converted into commercial banks.
  • In the third phase after 1993-94, the prominence of development banking declined, as liberalization resulted in the exit of some firms from development bankingand in a waning in the resources mobilized by other firms.

 

Categories of DFIs:

1- National Development Banks such as IDBI, SIDBI, ICICI, IFCI, IRBI, and IDFC.

2- Sector-specific financial institutions such as TFCI, EXIM Bank, NABARD, HDFC, and NHB.

3- Investment Institutions such as LIC, GIC and UTI.

4- State-level institutions such as State Finance Corporations and SIDCs.

 

Classification of DFIs:

1– Sector Specific Financial Institutions: They focus on particular sectors to provide finance for the project. For example, Export-Import Bank (EXIM Bank) was established in January 1982 and is the apex institution in the area of foreign trade investment. National Bank for Agriculture and Rural Development (NABARD) was established in July 1982. It is the apex institution in the area of agriculture and rural sectors. National Housing Bank (NHB) was established in 1988. It is the apex institution in Housing Finance and so forth.

2- Investment Institutions: They focus on facilitating business operations such as capital expenditure financing and equity offerings. For example, GIC, UTI and more.

 

Need for DFI (present scenario)

  • India is today an attractive destination for foreign funds. Debt and equity capital markets are increasingly dynamic. Insurance companies, fund houses etc. are active in loan/bond buyout and/or refinance, particularly for completed projects.
  • Financing activities:The DFIs extended term loan for setting up new units as also for expansion, modernization and rehabilitation of existing units. There are no sect oral restrictions (except for the small negative list)
  • NPA Crisis:The surge in NPAs in the banking sector, and the need to augment financing of infrastructure for kick-starting the growth cycle have led to a renewed policy attention on setting up DFIs.
    • The gap between banks’ assets and liabilities, already increased by bad debts will become unsustainable in infrastructure investment, given the long funding periods of such projects.
  • Economic Crisis Triggered By Covid-19 Pandemic
    • The Covid-19 pandemic has exacerbated inequality, the poverty gap, unemployment, and the economy’s slowing down.
    • Thus, infrastructure building through DFIs can help in quick economic recovery.
  • Achieving the Target of $5 Trillion Economy:The government has envisaged attaining the target of becoming a USD 5 trillion economy by2025.
    • However, this goal will depend on world-class infrastructure across the country.
    • NITI Aayog has estimated that US$4.5 trillion will be needed by 2030 to fund infrastructure. DFI is a step in the right direction towards this goal.
  • International Examples:DFIs in China, Brazil, and Singapore has been successful in both domestic and international markets.
  • Asset Liability Mismatch: Commercial banks face a maturity mismatch. Commercial banks borrow short from depositors with a maximum of 10 years for fixed deposits and therefore cannot offer medium and long term loans for projects requiring 15-25 years of funding.
  • Many commercial banks (both public and private) are already struggling to cope with rising bad loan and stretched balance sheets. Hence, the sharp decline in long-term credit witnessed in the last two decades has revived the demands for creating new DFIs and development banks in India.

Way Forward

  • Mobilizing Capital For DFI:To lend for the long term, DFI requires correspondingly long-term sources of finance.
    • DFIs of the earlier era were over-reliant on cheap government funds and today’s commercial banks ran into asset-liability mismatches due to their reliance on retail deposits to fund long-term projects.
    • Therefore, it may be best for new-age DFIs to focus on diversified sources of funding.
    • Presently, DFI can be adequately capitalized by the sovereign-backed funds, alternative routes such as capital gains/tax-free bond issues, external borrowings, and loans from multilateral agencies.
  • Specialized DFIs:Specialized project lenders focused on specific verticals tend to do better at building project appraisal skills and managing risks than ‘supermarket’ lenders who fund any project that comes their way.
    • The Centre must therefore be open to the idea of multiple specialized DFIs modeled on the success of refinancing institutions such as NHB and NABARD.
  • Ensuring Good Governance: While freeing a DFI from political interference or corny lending is necessary, merely having private shareholders or professional managers on board isn’t sufficient to ensure good governance.
    • This has to be backed by a robust system of external checks and balances such as supervision by RBI and proper due diligence by auditors and rating agencies.
  • Ensuring Ease of Doing Business:In the past, ambitious highway and pipeline projects have been continually held up by local protests and land acquisition woes, retrospective taxes, and poor contract enforcement.
    • The success of DFIs is contingent on ironing out such issues and removing on-ground impediments to the ease of doing business.
  • Likely challenges of NaBFID:It is likely to face challenges of intense completion from multiple players. Necessary condition for the proposed DFI to sustain will be its ability to
    • Retain low-cost advantage on a continuing basis,
    • Withstand market competition and
    • Navigate challenges of asset inflexibility – exclusively infrastructure.

Conclusion

While boosting investment in the infrastructure sector is imperative for sustained growth, the need for the hour is to resolve persistent issues in the debt market that impede long-term financing flow. Hence, our Govt. need to revive DFIs concept again to keep societal, cultural, regional, rural and environmental concerns intact while sanctioning credit to long term infrastructure projects. Success of National Bank for Financing Infrastructure and Development (NaBFID). in imparting bond/debt market vibrancy will be an important and a positive step in continuation of India’s endeavor in developing a robust financial structure.

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