Stop Tinkering With Provisioning for Project Loans and Replace Loans With Bonds

If the RBI wants Indian banking and non-banking financial institutions to be in good health, it should let go of its iron grip over the government bond market.

(Photo altered by Kamran Akhter)

Much consternation, handwringing, and lobbying have been underway since the Reserve Bank of India (RBI) mandated higher provisioning for project lending, early in May. It has asked banks and non-banking finance companies like Power Finance Corporation to set aside as much as five percent of their project lending to provide against the loan turning sour.

This Tuesday, the Economic Times reported that the RBI might consider staggering the provisioning requirement over a number of years. No sigh of relief should meet the delivery of pain in homeopathic doses, rather than in one shot. The real question is, why should projects still raise debt capital as loans, rather than via bond issuance?

If the RBI wants Indian banking and non-banking financial institutions to be in good health, it should let go of its iron grip over the government bond market, hand it over to SEBI (Securities and Exchange Board of India) for regulation jointly with the market for corporate debt, and encourage loan providers to focus on smaller borrowers, who cannot readily access the bond market.

In India, we have a peculiar situation, in which 80 percent of small and medium enterprises complain they have no access to formal finance, even as big corporates that enjoy sound credit ratings take the bulk of their debt as loans from banks and specialised NBFCs, such as PFC, Rural Electrification Corporation, Railway Finance Corporation, etc.

The Four Essential Functions of Banks

Banks are supposed to perform four essential functions, when they mediate savings to investment, that is, collect the public’s savings as deposits and make them available as debt to those who set out to create fresh value by making use of capital.

One, they agglomerate savings, so that someone who needs a large amount of capital is spared the hardship of identifying thousands of small savers willing to lend to them, and offering them all rates of interest acceptable to each lender.

Two, they elongate maturity, creating money in the process. The pool of savings into which a bank dips to give out loans is constantly refilled, even as savers who withdraw their deposits keep draining it so that the bank can make loans longer than the average maturity period of its deposits, with money they do not have, that is, by creating money.

When your newspaper vendor collects his bill for a month’s supply of newspapers at the end of the month, he has created money, letting you consume a month’s newspaper supply worth of goods and services more than you could have, in the absence of such credit. The banks do this on a much grander scale.

Three, they mitigate risk, for the saver, and for the borrower. The saver does not have to worry about the risk profile of those who tap her savings, she just hands over her money to the bank. It is the bank’s job to assess the risk of potential borrowers and calibrate the risk premium on loans according to the probability of default. It is the bank’s headache to secure the repayment obligation to the depositor, by taking recourse, such as collateral on loans, debt recovery mechanisms, and deposit insurance.

And, four, by doing all the above functions, a bank lowers the cost of mediating savings to capital deployment.

In India, banks take the lazy way out. The bulk of their funds go to the largest, safest corporates – whether with a nudge from the powers that be or otherwise is a different question. Other loans go to those who can offer collateral worth more than the loan being handed out. The core function of assessing the risk of a venture, for which the loan is being sought, is something India’s banks rarely perform.

Replace Loans With Bonds

The way to change this is for large companies to raise debt by issuing bonds, while banks focus on the small borrowers they currently service grudgingly, because of the priority sector lending obligations imposed by the regulator.

Total corporate bonds outstanding in India, at the end of March 2024, stood at Rs 47,28,935.67 crore, or under 17 percent of GDP. The corporate bond market in the US is 120 percent of GDP, close to 90 percent of GDP in South Korea, and close to 60 percent in Malaysia. It is nearly 40 percent even in China, where financial markets are not particularly developed, and people invest in second and third homes, rather than in mutual funds or pension funds.

Banks are not equipped to lend for long gestation infrastructure projects. Even if they extend the tenor of their loans beyond the maturity period of their own liabilities, that is, deposits, there is a limit to this stretch. Bonds issued by a toll road or a bridge project, which can afford an extended payback period, can have long tenors, so as to avoid high tolls and user charges. Loans cannot stretch that long.

Life insurance companies, pension funds, etc, would prefer to invest in bonds that mature when their payout obligation approaches, and keep paying returns till then. In other words, there are investors who are actively looking for bonds with long maturities. In any case, since bonds are tradable, short-term investors can also buy long-term bonds, stay invested for as long as they want to, and sell them off when they want to exit.

If infrastructure projects are financed by bonds, rather than loans, the need for provisioning against the loans would disappear. There are other benefits, too. When banks lend to large projects, a small committee of lenders needs to be persuaded about the validity and viability of the project. Extraneous considerations, including political pressure, could play a role.

Bond issuances are evaluated by credit rating agencies, mutual funds, pension funds, insurance companies, investment advisors, and assorted financial analysts, including short sellers. Any inherent weakness in the project would be spotted and highlighted in the process, eliminating cost padding.

Project financing would cease to be an avenue for transferring the public’s funds to private accounts, which routinely happens at present during the course of project implementation, once inflated project costs are sanctioned and financed by lenders.

Bond trading in India is inhibited by the split into two separate markets for government bonds and corporate bonds, and the absence of a vibrant market for risk mitigation instruments, such as credit default swaps, interest and currency risk mitigating derivatives. SEBI has been trying to promote the bond market, lowering the minimum ticket size for investing in bonds to Rs 10,000, with a clearing mechanism for corporate bonds, by setting up a promotional fund.

The RBI must join the effort, and make bond financing of infrastructure and other projects the norm, rather than the exception. Ironically, by prescribing high provisioning for infra lending, the RBI is making bank loans for infrastructure very expensive, increasing the appeal of the bond financing option. That is the way to go.

(The author is a senior journalist and formerly the Editor of Opinions at the Economic Times. This is an opinion article and the views expressed above are the author’s own. The Quint neither endorses nor is responsible for them.)