Déjà vu on DFIS AARTHIKAM CHINTANAM
The bank-led model of infrastructure financing is fraught with difficulties. But DFIS are not a quick fix
It is reported that the government is working towards reviving Development Finance Institutions (DFIS) for funding infrastructure projects, in order to address the rising challenges of infrastructure financing. In the past, DFIS have not worked well; it is hence useful to place and assess this move in historical context.
It is important to diagnose why previous attempts worked out poorly, and bring that institutional memory into the next take on the problem. Some argue that solving deeper problems, and making the Indian financial system work, is a long-term project, while the benefit of building a DFI right now will be obtained rapidly. However, a little “aarthikam chintanam” shows that for a new DFI to build up a meaningful balance sheet size will also require time. So if a DFI is being created, alongside careful steps in building it, the government should, in parallel, address the long-standing policy difficulties of Indian finance.
Let us briefly look at how we got here. In the 1950s, finance in India was primarily debt financing, as the bulk of the risk-taking was done by government and public sector units (PSUS). The intellectual framework involved banks that would deliver working capital and short-term finance, and a new class of financial firms termed as the Development Financial Institutions to produce long-term finance.
The first DFI was the Industrial Finance Corporation of India (IFCI) established in 1948. This was followed by the setting up of State Finance Corporations (SFCS) at the state level after the enactment of the SFCS Act, 1951. Some other DFIS set up during the early phase of planned economic development were ICICI Ltd in 1955, and UTI and IDBI in 1964. A second generation of DFIS were set up as sector specific FIS or financial institutions in the 1970s and 1980s, including NABARD, EXIM Bank, NHB and IRFC. Among the third generation DFIS are IDFC and IIFCL that were established in the liberalisation phase of the 1990s.
At many points in this journey, when policymakers saw an infirmity in the working of the financial system, their response was not to solve the underlying deeper failures of financial policy, but to start one more DFI.
But we must ask: Why can a DFI do useful things that a private financial firm cannot? A little examination shows that DFIS have been subsidised by the exchequer. There was concessional financing from the Reserve Bank of India or RBI (which thereby drifted into a fiscal function). They also had access to cheap funds from multilateral and bilateral agencies intermediated by the Government of India which absorbed the foreign exchange risk of these loans. The bonds issued by DFIS qualified as statutory liquidity ratio investments by banks, so channelling bank resources to DFIS was one part of the Indian system of financial repression.
When financial reforms began, these elements of special treatment of DFIS were partly wound down, and the viability of many of these organisations came under threat. There is a risk management problem when a balance sheet is constructed using short-dated borrowings and long-dated risky assets. The difficulties of a weak business model, poor incentives, moral hazard associated with government involvement, and weak regulation translated into business failure. Multiple committees of the RBI have concluded there are structural problems in the concept of a DFI, and have recommended conversion into banks (e.g. IDBI and ICICI) or non-banking financial companies (NBFCS).
Attempts at building a DFI today need to draw on this institutional memory, of the challenges experienced from the 1990s onwards, where organisations like IFCI, IDBI and ICICI experienced difficulties. That knowledge will be useful in evolving better structures.
In the 1990s, with an increasing role for the private sector in the economy, it came to be understood that Indian finance required capabilities in both equity and debt. With the establishment of the securities market regulator Sebi, and other institutions like non-conflicted stock exchanges, depositories and clearing corporations, revolutionary gains were achieved in equity market development and market regulation. However, on the debt side, paradoxically, the progress was much less; the foundations of the debt market have yet to be laid. This constrains infrastructure financing and also constraints the possibilities of what Dfi-like organisations can do.
The dissatisfaction in the minds of policymakers about the state of infrastructure financing is well placed. The bank-led model of infrastructure financing, which played a leading role in the economic boom of 2002-2011, was fraught with difficulties. The uncertainty and maturity profile of cash flows from infrastructure projects are not well suited for bank balance sheets. A solution to this problem is essential, given that over ~100 trillion of infrastructure financing is estimated as the requirement in the coming decade.
The attraction of building a DFI today lies in the sense that it can help in the short run. While setting up a new organisation with a balance sheet of ~0.1 trillion is not hard, there are considerable challenges in scaling up. The new DFI will not make a material impact upon the economy until its balance sheet is a couple of trillion rupees. But building up to a balance sheet of a couple of trillion rupees, safely, is a slow process
While setting up a DFI seems like a quick fix, it is actually a slow fix. Deeper reforms are slow, but have the highest influence, because changing laws and regulation harnesses the energy and balance sheets of private persons.
When faced with the opportunities in Indian software/ites in the late 1980s, policymakers could have started an “Indian High Technology Finance Corporation”. But instead, the path towards deeper reforms was established through the G S Patel Committee report of 1984, which set the stage for the reforms of the early 1990s, that led to trillions of rupees of capital that have gone into software/ites companies in the recent decades.
The complete understanding of the problems of financial policy, debt markets and infrastructure financing is in hand, with committee reports and draft laws. Alongside the long range project of building a DFI, it is worth also undertaking the long range project of financial reform.