Nostalgia holds lessons for new financial institutions

British band Pink Floyd’s 1978 stylised rock opera, The Wall, was a searing commentary on alienation, disjointed families, cruel societies and war, including its twee evocation of World War II nostalgia: “Does anybody here remember Vera Lynn?” The Indian government’s current legislative run similarly induces nostalgia that, hopefully, will not overlook lessons learnt from past mistakes.

On 23 March, the Lok Sabha passed The National Bank for Financing Infrastructure and Development (NBFID) Bill, 2021, seeking to establish a development finance institution (DFI) to fund infrastructure. This was finance minister Nirmala Sitharaman fulfilling her budget promise. The government will initially own 100% of the proposed NBFID’s ₹20,000-crore share capital, which will be reduced later to 26% by selling equity to banks, multilateral institutions, sovereign wealth funds, pension funds and insurers.

The government will also support NBFID in raising cheap, long-term finance. Apart from the initial share capital, the government will also provide a ₹5,000-crore grant at the end of its first financial year, presumably to defray initial costs; it has also committed to guarantee, at negligible cost, NBFID’s borrowings and bond issuances in the domestic and overseas markets. In addition, the government will underwrite NBFID’s foreign exchange hedging costs.

These are comfort factors for any infrastructure financing agency set up in India. DFIs of the pre-reform era were converted into commercial banks (or languished) after their access to cheap finance dried up. DFI bonds were earlier eligible for investment by banks to meet their mandatory statutory liquidity ratio (SLR) requirements, so that paper had ready takers. Once the SLR tag was removed, DFIs could raise only short-to-medium-term finance at market rates. This demolished their core business model. NBFID’s future seems somewhat secure on that count.

But there are other concerns. It might be instructive to study the fortunes of two infrastructure financing institutions set up in the public sector with direct and indirect government stakes: IL&FS Ltd and IDFC Ltd. The problems dogging IL&FS and IDFC are seemingly different on the surface, but similar at their core.

The problems of IL&FS, set up in 1990 as a non-banking financial company, have now been well documented after its collapse in 2018. IL&FS had borrowed short-term loans to finance long-term infrastructure assets and was thrown off this unstable carousel when a slowing economy and political interference forced infrastructure borrowers to stop repaying loans. Also, it had grown unwieldy, was mismanaged, and escaped scrutiny for too long by handing out plum postings to select bureaucrats.

P. Chidambaram’s July 1996 budget speech announced the setting up of IDFC to address the lack of long-term infrastructure financing, with both the government and Reserve Bank of India (RBI) contributing ₹500 crore each as start-up capital. In 2004, interference by Delhi-based bureaucrats ignited an internal rebellion; seven senior executives resigned, which included then managing director Nasser Munjee and chief policy advisor Urjit Patel (appointed RBI governor in 2016). Sounds familiar? Delhi mandarins were upset with the slow growth of infrastructure loans; the executives said that the book was growing cautiously due to lack of bankable projects. Cut to 2021. IDFC, created originally to finance infrastructure projects, has since then wound down its project finance book. It transferred its lending business to IDFC First Bank, which has more than halved its infrastructure book from ₹26,832 crore in March 2018 to ₹11,602 crore by December 2020. Former bureaucrat and current IDFC Ltd chairman Vinod Rai’s statement in its 2019-20 annual report is revelatory: “…we continued steadfast on our charted strategic direction of divesting non-retail businesses and investing to grow our retail businesses…We have now completely exited our non-retail businesses.” Ironically, as a government nominee on IDFC’s board in 2004, Rai was part of an effort to convert IDFC Ltd into a State Bank of India subsidiary because it was not disbursing infrastructure loans fast enough.

Sitharaman’s 2021-22 Budget speech also mentioned the creation of another institution which will acquire the banking sector’s stressed assets, manage them and eventually dispose them. Cue the Pink Floyd song again: “Does anybody here remember Industrial Investment Bank of India?” Launched in 1971 as Industrial Reconstruction Corporation of India, then renamed Industrial Reconstruction Bank of India and finally re-purposed as Industrial Investment Bank of India, the institution was eventually shut down in 2012. Mandated with nursing sick and weak companies, it collapsed under this onerous burden, betrayed by a campaign finance system that favoured embezzling entrepreneurs over a robust resolution process.

The short lesson is this: Fix the distorted demand side before increasing supply. Any number of institutions can be launched, but cannot be expected to work miracles in a corroded system. Bankers at Mint’s Annual Banking Conclave in February 2020 had one recurring collective concern: banks can price commercial, operational or market risk, but have no control over political risk, which has hobbled many infrastructure projects in India. No financing institution can address this problem.

Rajrishi Singhal is a policy consultant, journalist and author. His Twitter handle is @rajrishisinghal.