[Aman and Anurag are students at National Law University, Delhi, and School of Law, Christ (Deemed to be University), respectively.]
In her recent budget speech, Ms Nirmala Sitharaman, the Finance Minister of India, announced the government’s plans of setting up a Development Financial Institution (DFI) in order to boost infrastructure financing. In her speech, the Finance Minister indicated that the government recognizes the need for long-term debt financing in the infrastructure sector, and it would introduce a bill in Parliament to set up a DFI. The government has now proposed to set up a 100% government-owned DFI in the form of the National Bank for Financial Infrastructure and Development (NaBFID). This article analyses the role to be played by the government in such a DFI structure and recommends certain checks that may be considered by the government while setting up NaBFID.
Proposed DFI by the Indian Government
On 25 March 2021, the Parliament passed the National Bank for Financing Infrastructure and Development Bill 2021. NaBFID has been conceptualized as a facility that would be used to fulfill the long-term financing needs of the infrastructure sector. It will operate as the principal financial institution and a development bank for creating a support ecosystem for infrastructure projects. Banks and other financial institutions find it difficult to finance infrastructure projects owing to their risky nature and the long-time commitment involved. In this context, NaBFID shall play a particularly vital role in the infrastructure sector. NaBFID would be set up with a capital base of approximately INR 20,000 crore and is reported to have a lending target of INR 5,00,000 crore in 3 years.
Why Did Previous Experiments Fail?
The concept of DFIs is not new in India. Post-independence, the following DFIs were set up by the Indian government viz. Industrial Finance Corporation of India (IFCI), Industrial Credit and Investment Corporation of India (ICICI), and Industrial Development Bank of India (IDBI). These institutions aimed at providing long-term capital funding to the industrial segment. Subsequently, the government also introduced sector-oriented DFIs such as the National Housing Bank, and Housing and Urban Development Corporation.
While the concept of DFIs was prevalent in India, most of the established DFIs failed in fulfilling their objectives. The primary reason for the failure of DFIs, IFCI for instance, can be attributed to their high cost of fund generation and the absence of a robust monitoring mechanism. Due to the eventual inability of the DFIs to raise funds at concessional rates from alternative sources, they were compelled to raise funds at market rates from banking facilities. This had a ripple effect on the interest rates commanded by the DFIs for project financing, often rendering the resultant rates to be higher than standard market rates. Such high-interest rates consequently caused the infrastructure projects to be commercially unviable for the borrowers. This created the hurdle that led to the downfall of DFIs – borrowers turning into non-performing assets (NPAs).
Further, the long gestation period and the resultant uncertainties related to infrastructure projects exacerbated the problem. These uncertainties arose from government regulations, litigations, and like factors. These factors led to an asset-liability mismatch, resulting in the eventual downfall of DFIs in India. This downfall saw the conversion of the erstwhile DFIs such as ICICI and IDBI into universal banks. Taking into account the pertinent asset-liability mismatch, the Reserve Bank of India (RBI) in its Annual Report for 2019-2020 suggested that the excessive dependence on bank-based systems for the financing of infrastructure be reduced for the benefit of the economy.
Moreover, while the DFIs had access to subsidized credit from the government, this model was arguably unsustainable. This was because the bad performance of these DFIs resulted in their losses being passed on to the government. For instance, the RBI had set up the National Industrial Credit (Long Term Operations) Fund to enable loans and advances for eligible DFIs. However, the same was withdrawn in 1992-1993 owing to the poor performance of the institutions. In the absence of such a subsidy, the DFIs had to substitute funding sources with debt markets. However, the problem with the Indian debt markets lay in its high illiquidity. Therefore, the DFIs did not have access to cheap funds anymore, forcing the DFI model into duress. This was one of the major reasons for the conversion of the aforementioned DFIs into universal banks.
All the aforementioned factors direct us towards a very pertinent issue in the extant DFI model - the role of government in ensuring that the DFIs have a stable and sustainable source of fundraising. In the extant model, regulatory restrictions on certain types of financial institutions, such as insurance funds and pension funds, made it difficult for private entities to participate in infrastructure financing via DFIs. However, in the proposed NaBFID, this issue shall be adequately resolved by attracting insurance and pension funds to invest in the NaBFID.
How Does DFI in the European Union Function?
Before understanding the role that the Indian government should play in ensuring the stability of DFIs, we shall peruse the functioning of DFIs in the European Union. The European Development Financial Institutions (EDFI), which is an association of 15 European Bilateral Development Finance Institutions, published a report on the functioning of DFIs in the EU. The report throws light on the relations that the governments have with the DFIs. In the EU, the DFIs generally source their capital from national or international development funds. However, they also benefit from government guarantees. The government guarantees ensure the creditworthiness of such institutions. The report also suggests that for the proper functioning of the DFIs, they should tap into the private investors to ensure that the DFIs have a more stable model. Therefore, it can be inferred that the DFIs in the EU leverage the government involvement to tap into the private sector.
Role of the Indian Government in the DFIs
In order to understand the role that the government should ideally play in DFIs, it is imperative to examine the ownership structure in the erstwhile Indian DFIs. IFCI, which was India's first DFI, started out as a statutory corporation in 1948. However, because of its inability to perform as per expectations, the constitution of IFCI was changed in 1993, from a corporation to a company under the Companies Act 1956. This was done to enable IFCI’s access to the capital markets. Similarly, IDBI, which was incorporated as a wholly-owned subsidiary of the RBI, was transferred to the government in 1976. The government subsequently transformed it into a commercial bank by virtue of the IDBI (Transfer of Undertaking and Repeal) Act 2003. A pattern noticeable across these institutions is the government’s eventual disinvestment to make the DFIs a more viable funding option. While the 100% government ownership in the NaBFID is a positive move that instills confidence in the industry, it may also impact the functioning of the model if such involvement of the government is not moderated.
While in an ideal scenario, a government-owned and controlled DFI would have the benefit of receiving subsidized funding and gaining the trust of the industry, it might also lead to a risk-averse attitude in the management. This would eventually have a direct effect on the functioning of the DFI, thereby defeating the very purpose behind its creation. Contrarily, a DFI owned and controlled by private players may ensure a higher risk appetite. This can be achieved by making the government a minority stakeholder in the DFI, while the majority stake lies with the private sector. Such an arrangement would ensure a swift and efficient decision-making process, greater liquidity for projects, and a higher risk-tolerant model.
Moreover, the government can take several steps, while being a minority stakeholder, to ensure a sustainable model for the DFI. This includes streamlining regulatory compliances for the projects to ensure timely completion and returns on investment. The government should ensure that the NaBFID is a professionally managed institution that is free from any political interference. The same may not be possible in case the DFI is a wholly government-owned institution. As aforementioned, if the government considers being a minority stakeholder in the DFI, it would open doors for participation from private equity investors and other institutional investors, thereby attracting technical expertise and professional resources to the DFI in addition to capital.
In the future, the government may also consider listing the DFI on a stock exchange through an initial public offering. The same would further decrease the cost of raising capital while improving the corporate governance and decision-making of the DFI. It would also ensure that the DFI functions in accordance with the market forces and under the scrutiny of regulatory authorities. Therefore, rather than complete government ownership of the DFI, minority ownership by the government while privatizing the remaining stake would help sustain the fiscal health of the institution in the longer run.