100% Government-Owned Development Financial Institutions: Is It A Sustainable Model?

Author: ASHIQUE MUHAMMED BIN KAMAL

The government has now recommended that the National Bank for Financial Infrastructure and Development be established as a 100 percent government-owned DFI (NaBFID). This article examines the government’s involvement in such a DFI structure and suggests certain checks that the government should consider while establishing NaBFID. Ms Nirmala Sitharaman, India’s Finance Minister, outlined the government’s plans to establish a Development Financial Institution (DFI) to improve infrastructure finance in her recent budget speech. The Finance Minister stated in her speech that the government acknowledges the need for long-term debt financing in the infrastructure sector and that a bill to establish a DFI would be introduced in Parliament.

Indian government’s proposed DFI

The National Bank for Financing Infrastructure and Development Bill 2021 was passed by Parliament on March 25, 2021. The NaBFID was conceived as a facility that would be used to meet the infrastructure sector’s long-term financing needs. It will serve as the primary financial institution and development bank for the creation of an infrastructure support ecosystem. Due to the risky nature of infrastructure projects and the long-term commitment required, banks and other financial institutions find it difficult to finance them. In this regard, NaBFID will be especially important in the infrastructure sector. NaBFID is expected to be set up with a capital base of around INR 20,000 crore and a lending aim of INR 5,00,000 crore in three years.

What went wrong with the previous experiments?

DFIs are not a new concept in India. The Indian government established the Industrial Finance Corporation of India (IFCI), Industrial Credit and Investment Corporation of India (ICICI), and Industrial Development Bank of India after independence (IDBI). These institutions were created with the intention of providing long-term capital investment to the industrial sector. Following that, the government established sector-specific DFIs including the National Housing Bank and the Housing and Urban Development Corporation. While the concept of DFIs was popular in India, most of the existing DFIs failed to achieve their goals. The fundamental cause for DFIs’ failure, such as IFCI, can be linked to their high cost of fund generation and lack of an effective monitoring mechanism. DFIs were forced to raise financing at market rates from banking facilities when they were unable to raise cash at concessional rates from alternate sources. This had a knock-on impact on the interest rates demanded by DFIs for project finance, resulting in rates that were frequently higher than market rates. As a result of the high interest rates, infrastructure projects became commercially unviable for the borrowers. This established the barrier that led to DFIs’ demise — borrowers becoming non-performing assets (NPAs).

Furthermore, the situation was compounded by the long gestation period and the resulting uncertainty associated with infrastructure projects. These uncertainties emerged as a result of government policies, lawsuits, and other similar circumstances. These circumstances resulted in an asset-liability mismatch, which eventually contributed to the demise of DFIs in India. As a result of this downturn, former DFIs like ICICI and IDBI became universal banks. In its Annual Report for 2019-2020, the Reserve Bank of India (RBI) proposed that excessive reliance on bank-based systems for infrastructure financing be decreased for the benefit of the economy, taking into account the relevant asset-liability mismatch.

Furthermore, while the DFIs got government-subsidized loans, this model was arguably unsustainable. This was due to the fact that these DFIs’ poor performance resulted in their losses being passed on to the government. The National Industrial Credit (Long Term Operations) Fund, for example, was established by the RBI to provide loans and advances to eligible DFIs. However, due to the institutions’ poor performance, it was revoked in 1992-1993. In the absence of such a subsidy, the DFIs were forced to rely on debt markets as a source of funding. The issue with Indian debt markets, on the other hand, was their extreme illiquidity. As a result, DFIs no longer had access to low-cost capital, putting the DFI concept under strain. One of the main motivations for the conversion of the aforementioned DFIs into universal banks was to address this issue.

All of the aforementioned considerations point to a critical concern in the current DFI model: the government’s involvement in ensuring that DFIs have a secure and long-term source of funding. Regulations on certain types of financial institutions, such as insurance funds and pension funds, make it difficult for private firms to participate in infrastructure funding through DFIs in the current format. This issue, however, will be appropriately addressed in the proposed NaBFID by enticing insurance and pension funds to invest in the NaBFID.

How does the European Union’s DFI Work?

We will examine the functioning of DFIs in the European Union before understanding the role that the Indian government should play in guaranteeing their stability. A report on the functioning of DFIs in the EU was produced by the European Development Financial Institutions (EDFI), an association of 15 European Bilateral Development Finance Institutions. The report sheds insight on the government’s relationship with the DFIs. DFIs in the EU often get their funding from national or international development sources. They do, however, receive government guarantees. The government ensures that these institutions are creditworthy. The report also proposes that, in order for DFIs to work properly, private investors should be tapped to ensure that the DFIs have a more robust model. As a result, it can be deduced that DFIs in the EU take advantage of government intervention in order to tap into the private sector.

The Indian government’s role in DFIs

It is necessary to investigate the ownership structure of the former Indian DFIs in order to comprehend the role that the government should ideally play in DFIs. In 1948, India’s first DFI, IFCI, was established as a statutory corporation. However, due to its failure to meet expectations, IFCI’s constitution was changed from a corporation to a company under the Companies Act 1956 in 1993. This was done in order for IFCI to be able to access the capital markets. In 1976, the government took over IDBI, which had been incorporated as a wholly-owned subsidiary of the RBI. The IDBI (Transfer of Undertaking and Repeal) Act 2003 allowed the government to convert it into a commercial bank. The government’s ultimate disinvestment to make the DFIs a more feasible funding alternative is a pattern that can be seen across these institutions. While 100% government ownership of the NaBFID is a beneficial step that instils confidence in the industry, it may have an influence on the model’s functionality if the government’s engagement is not restrained.

While a government-owned and managed DFI would benefit from subsidised funding and the industry’s trust in an ideal scenario, it might also lead to a risk-averse mindset among management. This would eventually have a direct impact on the DFI’s operation, negating the fundamental goal for which it was created. A DFI owned and controlled by private actors, on the other hand, may have a higher risk appetite.This can be accomplished by making the government a minority shareholder in the DFI, with the private sector owning the majority. A deal like this would assure a quick and efficient decision-making process, more project liquidity, and a more risk-tolerant model.

Furthermore, as a minority partner, the government can take many steps to ensure the DFI’s long-term viability. This includes streamlining project regulatory compliance to enable timely completion and returns on investment. The government should ensure that the NaBFID is a professionally run organisation that is free of political meddling. If the DFI is entirely owned by the government, the same may not be achievable. As previously said, if the government contemplates becoming a minority shareholder in the DFI, it will open the door for involvement from private equity and other institutional investors, bringing with them technical expertise and professional resources in addition to finance.

The government may contemplate an initial public offering to put the DFI on a stock exchange in the future. The cost of borrowing money would be reduced even further, while the DFI’s corporate governance and decision-making would be improved. It would also guarantee that the DFI operates in conformity with market forces and is subject to regulatory oversight. As a result, rather than full government ownership of the DFI, minority government ownership combined with privatisation of the remaining portion would benefit the institution’s budgetary health in the long run.

References

https://www.moneycontrol.com/news/business/economy/exclusive-new-development-finance-institution-to-be-100-owned-by-govt-6455691.html/amp

https://www.google.com/url?sa=t&source=web&rct=j&url=https://en.m.wikipedia.org/wiki/Development_finance_institution&ved=2ahUKEwjvpsfWp-DzAhWwxzgGHWLdC3IQFnoECBEQAQ&usg=AOvVaw3IWfnzlMTTZTOnyLkfZkT3

https://prsindia.org/billtrack/the-national-bank-for-financing-infrastructure-and-develhttps://prsindia.org/billtrack/the-national-bank-for-financing-infrastructure-and-development-bill-2021opment-bill-2021

https://www.thehindu.com/news/national/parliament-passes-bill-to-set-up-national-bank-for-financing-infrastructure-and-development/article34160785.ece

https://www.edfi.eu/about-dfis/what-is-a-dfi/

https://www.google.com/url?sa=t&source=web&rct=j&url=https://legislative.gov.in/sites/default/files/A2003-53.pdf&ved=2ahUKEwikxZaKpuDzAhVpxDgGHYclDyMQFnoECAQQBg&usg=AOvVaw06PiNjoiGdG8gTyPgHvmYC

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