Mistakes India must avoid to make DFIS a success

Three key issues will be crucial for DFIS — the availability of long-term funds at a reasonable cost, private-sector ownership & professional management

Among the key reasons why development finance institutions (DFIS) could not survive in their earlier avatar was that a scarcity of long-term financing made the business model of such entities unviable. Now that DFIS are set to make a comeback, with the Budget proposing to set one up, three key issues seem crucial for their success — the availability of long-term funds at a reasonable cost, private-sector ownership, and professional management.

According to bankers, DFIS failed earlier because, among other things, a drying up of long-term financing prompted them to turn to banks. This inflated their cost of raising funds. As banks’ deposits were for the short term, they could not provide the longer-term funding that DFIS needed, thanks to asset-liability mismatch concerns. Over 40 per cent bank deposits are for less than a year, while 20-25 per cent are for over five years.

DFIS need long-term funds because they are involved in financing infrastructure and industrial projects, which usually have a long gestation period. Many DFIS were later turned into commercial banks — IDBI, ICICI and IDFC to name a few.

S S Kohli, former chairman and MD of India Infrastructure Finance Co Ltd, told Business Standard: “The first thing is that the cost of borrowing earlier was very high. That should be taken into account... if you want to grow infrastructure, the funds should be available at a reasonable rate.”

If DFIS were to raise long-term financing earlier, they could do so by floating 10year papers, given that they were in a position to sustain long-term liability. But investor behaviour began to change amid various risks associated with long-term papers, mainly the interest-rate risks, as the rate cycles became shorter.

“There was a time when interest rates would remain undisturbed for 10 years,” said Ashvin Parekh, managing partner, Ashvin Parekh Advisory Services. “But then came a time when the horizon became shorter: With the development of the interbank market, a lot of call money came into the economy. Long liability by institutional investors was no longer available. The change that started from 1995, took deep roots by 2000-2001, and investors for long liabilities became fewer and fewer.”

The Budget has proposed a capital of ~20,000 crore for the DFI and set an ambitious lending portfolio target of ~5 trillion in three years. One approach to ensure the availability of long financing could be getting equity participation of private-sector players instead of debt participation. This would also ease the burden on the Centre to infuse capital in the DFI every year.

“First, create a DFI but run it as a private-sector entity, like ICICI. Second, let long investors come in as equity partners, not debt partners. Create some instruments so that they can participate through equity. Only then will they own the assets. There might be overseas sovereign funds and pension funds that would be interested. This might ensure a continuous fund flow,” Parekh added.

The lack of a vibrant corporate bond market has often been cited as a hindrance to long-term funding. Infrastructure firms, often not rated very highly, were unable to tap this market earlier. “Corporate bond market is typically a market for highly rated corporate bonds. So, if you are not rated highly, say AAA or AA, you will not be able to raise funds,” explained CARE Ratings Chief Economist Madan Sabnavis.

“If we are talking of infrastructure and a DFI, it will never get an AA or AAA rating — for the simple reason that even as the money is borrowed today, the projects come up after four-five years. So, most infrastructure companies get a lower rating of BBB or A. These units, therefore, cannot meet the requirement of infrastructure funding in the corporate bond market,” Sabnavis added.

At present, inadequate liquidity in the secondary bond market is an issue, except for the top-rated bonds. As a result, investors can’t buy or sell corporate bonds freely.

One approach to ensure the availability of long financing could be getting equity participation of private players instead of debt participation