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There seems to be a growing consensus among policymakers and industry practitioners that India needs an institutional mechanism to improve financing for long-term infrastructure projects, notably by establishing a national development finance institution (DFI).

A DFI differs from a commercial bank in that its mandate balances positive development outcomes with profit maximization, often prioritizing the former over the latter. It typically provides necessary financing for activities that are in the realm of public good, but are not lucrative from a financial risk-return perspective, such as environmental projects, long gestation greenfield infrastructure projects and even supporting innovative startups.

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Theoretically, the establishment of a DFI could be justified by the dual existence of massive infrastructure needs and availability of bankable projects. Practically though, this raises a number of questions on how the DFI will fund itself in terms of equity and debt, and whether it should be brought under the ambit of the Reserve Bank of India’s regulatory prescriptions. These considerations will have a direct impact on the amount of infrastructure investments that the DFI could potentially finance in the country.

Funding sources

To be effective in its mandate of lending to long-term infrastructure projects, it is imperative that the national DFI is able to raise funds at competitive rates from capital markets, close to the levels of sovereign issued debt. Towards this objective, the DFI will benefit from 100% government ownership, providing it with cheaper equity as compared to commercial banks. To bolster its capital base, the DFI could issue quasi-equity instruments such as perpetual bonds and long-term subordinated debt that qualify as equity due to their loss absorption capabilities.

In terms of debt funding, it is likely that the bulk would be raised from bond issuances in domestic and international capital markets. The demand for domestic bonds could be enhanced if the RBI qualifies these bonds as highly liquid instruments (eligible for statutory liquidity ratio, or SLR, and liquidity coverage ratio, or LCR) and allows banks to invest in these bonds with a risk weight akin to sovereign bonds. International issuances can include Masala bonds, external commercial borrowings (ECBs) and foreign currency convertible bonds (FCCBs), within the allowed regulatory parameters.

Another important source of low-cost funds for the DFI is to receive loans from multilateral development banks, for on-lending to infrastructure projects in India.

Regulation

It is advisable that the national DFI be brought under the ambit of RBI’s regulatory prescriptions. From a risk management perspective, a development bank is no different than a commercial bank in that its capital levels are affected by economic cycles, and typically tighten during downturns. The mandate and operating model of DFIs also highlight the necessity for regulation and supervision. Their loan books are concentrated to a few sectors and constituted of large exposures, given their focus on financing large, infrastructure projects.

Because of its mandate, ownership structure and risk profile, it could be argued that a national DFI is more similar to All India Financial Institutions (AIFIs), such as EXIM Bank, NABARD, NHB and SIDBI, than to commercial banks. The significance of this distinction is evident from the fact that AIFIs are required to maintain a minimum leverage ratio (Tier 1 capital to total exposure) of 6% as compared to 3.5% for scheduled commercial banks (SCBs); although there is no difference in the minimum capital ratio (CRAR) requirement of 9% for both institution types. Put simply, for the same amount of capital, an AIFI would be able to create a smaller loan book as compared to a SCB.

Transformative impact

Combining the sources of equity and debt, and the regulatory limits applicable on these, it is possible to estimate how much infrastructure financing (measured via size of asset book) can be extended by the DFI in the medium to long term.

Let us assume the government infuses equity of $10 billion (approx. Rs72,000 crore). With additional quasi-equity instruments that qualify as Tier 1 and Tier 2 capital, the DFI could build a total capital base of around $16 billion. Now, targeting a leverage ratio of 6% and a CRAR of 9%, would allow a potential asset book of around $210 billion (approx. Rs15 trillion), even with conservative risk weight assumptions.

Similar to other financial institutions, it is likely that the DFI, too, will allocate sufficient capital buffers over regulatory prescriptions. This could reduce the potential size of the asset book. Illustratively, if the DFI targets a leverage ratio of 7.5% and a CRAR of 11%, the asset book would reduce to $150 billion (approx. Rs11 trillion). Even so, this would be equivalent to 11% of the National Infrastructure Pipeline (NIP) target that seeks financing for projects worth $1.4 trillion (approx. Rs100 trillion).

With the potential to extend 15 worth of infrastructure investments for every rupee of equity infusion from the government, the establishment of a DFI can play a truly transformative role in bridging India’s infrastructure financing gap.

Kamani is a professional at the Shanghai-based New Development Bank. Views expressed are personal and do not necessarily represent the views of the organization that the author represents.



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