Development Financial Institutions (DFIs)

WHY IN NEWS?

• National Bank for Financial Infrastructure and Development (NaBFID) is established as a Development Financial Institution (DFI) under the National Bank for Financial Infrastructure and Development Act, 2021.
• RBI will regulate and supervise it as an All-India Financial Institution (AIFI) under Reserve Bank of India Act, 1934.
• It will be the 5th AIFI after EXIM Bank, NABARD, NHB and SIDBI.

WHAT IS DEVELOPMENT FINANCIAL INSTITUTIONS

• A DFI is an institution that provides long-term finance for social and economic infrastructure where risks may be higher than what the ordinary financial system may be willing to bear.
• DFIs may or may not be state lead.
• DFIs do not accept deposits from people
• They raise funds by borrowing funds from governments and by selling their bonds to the general public
• It also provides a guarantee to banks on behalf of companies and subscriptions to shares, debentures, etc.

HISTORY:

• In India, the first DFI was operationalized in 1948 with the setting up of the Industrial Finance Corporation (IFCI).
• Subsequently, India’s Industrial Credit and Investment Corporation (ICICI) was set up with the World Bank’s backing in 1955.
• The Industrial Development Bank of India (IDBI) came into existence in 1964 to promote long-term financing for infrastructure projects and industry.
• However, during the 1970-80s, DFI got discredited for mounting non-performing assets, allegedly caused by politically motivated lending and inadequate professionalism in assessing investment projects for economic, technical, and financial viability.
• Due to these factors, Narsimhan Committee (1991) recommended disbanding of the DFI, and the existing DFI were converted into commercial banks.

SIGNIFICANCE:

DFIs play serve important objectives by extending credit (patient capital) for overall economic development. Funding from them is even more significant in developing countries because:

• Financing:
  • They provide funds to projects from Medium to Long Gestation periods with greater risks- in comparison to the acceptable limits of commercial banks and other financial institutions.
  • It is significant as long-term financing carries risks of delays or failure of projects, systemic concerns from banks due to asset-liability mismatch caused by long-term financing on banks balance sheet and lack of depth in the corporate bond market.
• Support Function:
  • Apart from financial help, many DFIs provide financial, managerial, and technical advice and consultancy to business firms for overall economic growth of the nation.
• Diversity of Options:
  • Based on DFIs functional classification, enterprises can get funds through bonds and debentures of the companies, underwriting of securities, refinancing of loans, and credit guarantee for loans from other foreign and domestic sources.
• Building Goodwill:
  • Loan from DFIs help companies in building goodwill, helping them to borrow from capital market and other sources as well.
• Crisis Funding:
  • DFIs help companies even in crisis or times of recession when other sources are not available or have high costs attached.
• Lesser Repayment Burden:
  • Through moratorium and easy repayment options for loan, the loan repayment burden on businesses is lesser than from other sources of funds.

NEED FOR DFI

• NPA Crisis:
  • The surge in NPAs in the banking sector, and the need to augment financing of infrastructure for kick-starting the growth cycle have led to a renewed policy attention on setting up DFIs.
  • The gap between banks' assets and liabilities, already increased by bad debts will become unsustainable in infrastructure investment, given the long funding periods of such projects.
• Economic Crisis Triggered By Covid-19 Pandemic:
  • The Covid-19 pandemic has exacerbated inequality, the poverty gap, unemployment, and the economy’s slowing down.
  • Thus, infrastructure building through DFIs can help in quick economic recovery.
• Achieving the Target of USD 5 Trillion Economy:
  • The government has envisaged attaining the target of becoming a USD 5 trillion economy by 2025.
  • However, this goal will depend on world-class infrastructure across the country.
  • NITI Aayog has estimated that US$4.5 trillion will be needed by 2030 to fund infrastructure. DFI is a step in the right direction towards this goal.
• Scale and complexity of infrastructure projects:
  • Infrastructure projects are complex, capital-intensive, and have long gestation periods that often pose risks to project financiers.
  • The scale and complexity of infrastructure projects make financing a challenge.
• Global success stories::
  • DFIs in China, Brazil, and Singapore have been successful in both domestic and international markets.

CHALLENGES:

• Sources of funds
  • The lack of a sustainable source of funds, however, can prove to be a serious constraint to the proposed DFIs.
  • Subsidised credit from the government and the Reserve Bank of India (RBI) has not proved to be a sustainable source in the past.
• Governance issues:
  • As DFIs are primarily owned by the Government, they are vulnerable to political interference affecting their decision making.
• Regulatory forbearance
  • There could also be need for some regulatory forbearance — the older DFIs (IDBI, ICICI) operated in an era with no regulatory norms for quite a while, save their own internal guidelines.
• Competence:
  • DFIs are supposed to be ahead of time with a strategy to meet the ambitious societal and economic change goals as well as the risks; raising such capabilities and skills within the management is a challenging task.
  • Additionally, for public DFIs it becomes difficult to compete with private players in attracting and retaining talented people due to wide pay gaps.
• Financial Sustainability issues:
  • DFIs have important role of development and often it takes precedence over profitability, leading to loses.
  • Example: After initial success, DFIs have faced survival challenges leading to merger with banks such as Industrial Credit and Investment Corporation of India with ICICI Bank (in 2002) and Industrial Development Bank of India with IDBI Bank (in 2004).
• Intense Competition:
  • Increased flow of foreign funds and options to raise money from outside has increased challenges for DFIs to retain their low-cost advantage, withstand competition etc.
• Other Challenges:
  • Issues of corruption
  • Lack of clarity on DFI mandates leading to lower operational efficiency
  • Limited flexibility in fund raising
  • Inadequate performance assessment or transparency etc.

WAY FORWARD:

• Diversified sources of funding:
  • DFI should be allowed to raise long-term financing from domestic and external sources.
    • Domestic: The DFI should be allowed to tap the pools of capital in the form of pension funds, insurance companies and mutual funds.
    • External: The DFI should also be allowed to raise long-term financing from external markets and from multilateral financial institutions.
    • Alternate routes: DFI can be adequately capitalized by the sovereign-backed funds, alternative routes such as capital gains, tax-free bond issues etc.
• Sound management structure
  • The DFI needs to have a sound management structure.
  • The government’s commitment to have a professional board with 50 per cent non-executive members in National Bank for Financial Infrastructure and Development is a step in the right direction.
• Broader coverage:
  • NABFID must also help take infrastructure beyond roads and power, because there are other crucial sectors, especially health, social and urban infrastructure (water supply, sanitation) that has more pressing needs.
• Allow flexible organisation structure
  • It is a prerequisite for agile organisation and to meet intense competition through operational flexibility
• Specialized DFIs:
  • Specialised project lenders focussed on specific verticals tend to do better at building project appraisal skills and managing risks than ‘supermarket’ lenders who fund any project that comes their way.
  • The Centre must therefore be open to the idea of multiple specialized DFIs modeled on the success of refinancing institutions such as NHB and NABARD.
• Ensuring Ease of Doing Business:
  • In the past, ambitious highway and pipeline projects have been continually held up by local protests and land acquisition woes, retrospective taxes, and poor contract enforcement.
  • The success of DFIs is contingent on ironing out such issues and removing on-ground impediments to the ease of doing business.
• Ensuring Good Governance
  • While freeing a DFI from political interference or crony lending is necessary, merely having private shareholders or professional managers on board isn’t sufficient to ensure good governance.
  • This has to be backed by a robust system of external checks and balances such as supervision by RBI and proper due diligence by auditors and rating agencies.
• Provide Adequate Safeguards for decision-making to address risk-aversion or fear of extra compliance
  • Example: the recent NaBFID act provides for prior sanction for investigation and prosecution- a safety net for decisions made in good faith
• Performance-based remuneration can help in retention of high-performing staff.
• Periodic reviews
  • Periodic reviews are necessary to ensure that the DFI remains relevant by taking into account changing priorities of the economy and making consequential adjustments in the role.
  • In India, we perhaps failed to review the mandates given to the DFIs in the past with view to enable them to change course to meet changing development priorities.

INTERNATIONAL EXAMPLES:

• European Investment Bank (EIB)
  • It acts like a DFI for Europe’s infrastructural development
• China Development Bank (CDB) and Agricultural Development Bank of China (ADBC)
  • These to two DFIs have been playing a pivotal role in the country's efforts to build infrastructure, manufacturing and agri-sectors.

CONCLUSION

• NABFID, with the support of the government, must go beyond being a provider of capital, to helping enable the return of private sector to infrastructure; else it could end up as just one more DFI in the financing spectrum.

PRACTICE QUESTION:

Q. Examine the relevance of Development Financial Institutions (DFIs) in post-pandemic rebuilding of Indian economy?