Will a new Development Finance Institution revitalize infrastructure?

The Modi government plans to set up a new Development Finance Institution (DFI) to facilitate the financing of big infrastructure projects across the country. India, however, has a long history of DFIs going back to the 1950s which have not turned out well. How is this new bank set up any different and will it be successful?

Development Finance Institutions (DFI) are financial institutions meant to deliver medium and long-term capital for productive investment, typically on a non-commercial basis. DFIs are considered necessary and were held to be especially important in the post-colonial era as they funded long-term capital-intensive projects like railways, irrigation systems, etc. better suited for the public sector. It is believed that the private sector could not be relied on for such investments because they require large lumps of upfront capital, have long gestation periods, and do not offer a competitive rate of return. Such investments in infrastructure are of national importance because they offer numerous long-term public benefits that cannot properly be captured by private players. Their separation from other public finance institutions theoretically allows them to develop a specialization in analyzing and monitoring long-term funding. Hence, the need for DFIs.

The first Indian DFI was the Industrial Finance Corporation of India (IFCI) in 1951 followed by the Industrial Credit and Investment Corporation of India (ICICI) and the Industrial Development Bank of India (IDBI). These got access to multiple sources of subsidized funds- ranging from concessional RBI credit to direct government financing. Some were even allowed to issue bonds that were classified as qualifiable under Statutory Liquidity Ratio requirements.

After the 1990s financial sector reforms, access to subsidized credit was eventually withdrawn. However, this was not replaced by lending from the bond markets which had failed to develop adequately. The DFI model had come into scrutiny and institutions like IDBI & ICICI were converted into banks. There are a number of problems with past DFIs that had been identified:

  • The major hurdle to infrastructural development in India is the long gestation period and the effort required to obtain government clearances and land acquisition. Much of the risk in infrastructure arises from uncertain timelines.

  • They finance industrial groups rather than new entrepreneurs because of old fashioned management which limits innovation

  • Their operations were, by and large, subpar: they did not properly monitor their loans, lending was subject to political influences, management was bureaucratic in its approach. Lack of a consistent lending approach due to changes in the government meant that despite the large number of funds provided, they failed to provide a reliable and professional source of finance which is crucial in the infrastructure sector

  • Their loans are heavily concentrated in certain industries that are always riskier

  • As opposed to universal banks which are also involved in retail lending, they do not have any income from outside their core business which increases its rate of lending.

  • This was one of the primary reasons why DFIs like ICICI and IDBI eventually merged with their retail banks. Doing so gave them access to low-cost bank deposits which allowed them to offer lower rates of interest, Prior to this, the interest rate on the loans they provided was quite high even after all the concessional funding from the government

Bank-led funding was tried in the early 2000s resulting in enormous growth in bank credit. But the global financial crisis meant repayments became highly uncertain and there were growing numbers of non-performing assets (NPAs ) in the banks’ balance sheets. Despite debt restructuring and lenders’ forums, bank loans became unreliable and there was a decline in the available credit which still continues to reduce. A new institution with no NPAs in its balance sheet could potentially expand the flow of credit in infrastructure. Increasing the supply of credit does not address the root cause of NPAs which is an improper assessment of projects’ viability and bureaucratic obstacles to timely project timelines. Funds lent by a new institution may just become the NPAs of tomorrow which chokes the credit supply.

The Government announced the new DFI in the Finance Minister’s budget speech, in line with its large commitments to infrastructure spending. It is expected that the institution will be up and running by Q3 of this fiscal year, as the government tables the bill for its formation in parliament. It is imperative for the government to fast-track the process if it is to meet its promise of 20L Cr. annual spending on infrastructure. It is possible that the build-up of bad loans might be averted through smarter risk management and more checks & balances to ensure objective management. The burden of a better institutional setup lies with the government. The initial capital outlay for the DFI in the budget is Rs.24,000 crores. However, it is possible for its budget allocation to increase incrementally over the next couple of years as the institution begins its functioning.

Boosting infrastructure is important but any DFI can attain success in the long term only by diversifying its finances through a vibrant bond market in addition to its public funding. It is hoped that this is followed by necessary capital market reforms. Several financial institutions like pension funds and insurance companies are disallowed to venture into long-term infrastructure finance through the bonds offered by these DFIs, which limits the liquidity in the market. The new DFI should also be forward-looking in its assessments of different projects, taking into account climate change risks and the lessons from impact investing. Another suggestion is adopting a portfolio approach by aggregating a number of projects while raising funds which lowers the risk on the overall financial instrument. We also need an alternate regulatory framework for such institutions, which considers how their working is different from traditional banks and is not anchored by existing banking regulation.


Further Readings:-

Technical Terms:-

  • Non Performing Assets: These are loans given out by banks that are in default or close to being in default. Many loans become non-performing after being in default for 90 days, but this can depend on the contract terms.

  • SLR or Statutory Liquidity Ratio: It is the required percentage of their deposits that banks are supposed to hold in the form of cash, gold reserves and certain financial instruments like bonds.

Edited by: Ayush Bakshi