Explained: The Role of Development Financial Institutions In Infrastructure Development

A World Bank survey defines a development bank as ‘a bank or financial institution with at least 30 per cent State-owned equity that has been given an explicit legal mandate to reach socioeconomic goals in a region, sector or particular market segment’. It uses the terms Development Bank and Development Financial Institution interchangeably.

According to UNCTAD, Development Banks are needed to bridge finance from end-savers to development projects. Such bridging should be done by Development Banks at all levels national, regional and international – in order to provide the financing needed in the developing world. Development Banks can thus be key players for development by providing long-term financing directly from their own funding sources, by tapping into new sources and by leveraging additional resources, including private, through the co-financing of projects with other partners.

In brief, Development Financial Institutions also designated as Development Banks are often equated with the institutions which supply the capital to meet economic development objectives.

These institutions are meant to provide long term finance to agriculture, industries, trade, transport, and basic infrastructure.

A DFI provides financing for development activities at less than strictly commercial terms. It delivers this through technical assistance grants, structured loans, different types of guarantees and credit enhancement and sometimes even equity.

It is interesting that in the discussions on development banking, no distinction is made between the bank and non-bank development finance institution. The terms Development Financial Institution and Infrastructure Finance Institution and National Development Bank and Development Financial Institution are often used interchangeably. But, these are essentially different types of institutions, with different purposes.

The distinction in case of development and infrastructure financing institutions concerns their respective financing purposes. Infrastructure is only one of the development sectors. Also, there are important differences between lending for industrial and infrastructure purposes. For a start, unlike the shorter-term working capital requirements of the industry, infrastructure requires long-term capital. Further, the risk-returns profile of infrastructure compared to industrial lending are very different. The risks, especially with construction, are much
higher than with many other sectors.

A Development Financial Institution (DFI) is an institution that provides long-term finance for development. The National Development Bank is a type of DFI. As the name suggests, it is a deposit-taking bank. In contrast, a majority of DFIs are non-deposit taking institutions.

The strength and resilience of banks arise from their access to information (about their customers) and their cash-flow patterns. The provision of short-term working capital sits well with their strengths. In contrast, the provision of long-term capital expenditure does not. Banks are therefore well placed to provide working capital finance, but face asset-liability mismatches when making long-term loans to infrastructure projects.

There are three different institutional forms for a DFI. First, deposit-taking wholesale banks. Second, non-deposit taking financial institutions. Finally, there are the off-balance-sheet entities like infrastructure funds. The RBI defines a non-deposit accepting, non-banking finance company, called Infrastructure Finance Company (IFC-NBFC). A minimum of 75 per cent of its assets should be in infrastructure loans, and it should have a minimum Net Owned Funds of INR 3 bn.

The wholesale banks could meet long-term financing requirements. Non-deposit taking institutions, with appropriate capital sources, are well placed to provide long-term capital. Off-balance sheet entities, while more likely to enjoy an arms-length relationship with their owners, could also create principal-agent related governance challenges. They could also be vulnerable to accumulating unsustainable leverage.

DFIs can be either wholly or partially owned by the government. A few have majority private ownership. The shareholding pattern is largely determined by the nature of the activities being financed, and their associated risk-returns profile.

Fully government-owned DFIs are risk-tolerant and are more likely to offer patient capital to invest in emerging technologies and infrastructure sectors. They would also be willing to accept less than commercial returns and offer debt at concessional terms. Further, such an entity will be able to ensure credit flows even in a downturn, thereby serving as an automatic economic stabilizer. Their objective function seeks to maximise development objectives, even at the cost of returns.

However, ownership introduces issues of governance. Governments usually do not maintain arms-length relationships with the management of organizations that they fully own. And DFIs that are majority privately-owned struggle to reconcile their pursuit of development objectives with shareholder preference for profit maximization.

There are two broad categories of incorporation and associated regulation in the case of financial institutions. There are institutional and instrument-based regulations. This can also overlap, with the institution itself having one regulator and a separate regulator for specific instruments offered by that institution.

There are some DFIs which are established directly by the statute. The statute prescribes the regulator for the institution. Currently, NABARD, NHB, SIDBI, and EXIM Bank are the only four statutory DFIs. The Reserve Bank of India regulates them under the Banking Regulation Act 1949.

The remaining are incorporated as non-banking financial corporations (NBFCs) under the Indian Companies Act 1956. Depending on the nature of their activities, they register with different types of regulatory agencies. The RBI, SEBI, NHB, IRDA, and Registrar of Companies are all regulators for different kinds of NBFCs.

In the context of financial market instruments, pooled investment funds not covered under the Securities and Exchanges Board of India (SEBI) (Mutual Funds) Regulations 1996, are regulated under the SEBI (Alternative Investment Funds) Regulations 2012. They include private equity, venture capital, hedge funds, infrastructure funds, etc.

Examples of instrumental regulation are the Infrastructure Debt Funds registered with the Securities and Exchanges Board of India while the issuing institution, the India Infrastructure Finance Corporation Limited (IIFCL) is institutionally under the regulation of the RBI and the National Infrastructure Investment Fund (NIIF) which is an Alternative Investment Fund regulated by SEBI.

Complicating matters, sometimes DFIs can be both a market maker in terms of refinancing or even direct lending, and also be regulating and supervising institution. In India, the National Housing Bank (NHB) does both refinancings of housing finance companies (HFCs) as well as
their regulation and supervision.

The funds for lending can come from either the government or the market. In this context, it is important to keep in mind that DFIs can serve their purpose of being catalytic if they have access to relatively cheap sources of financing.

So concessional or semi-guaranteed public debt, low-cost deposits, institutional savings, and government transfers are perhaps the most appropriate forms of capital for lending.

In the pre-liberalization era, the RBI printed money and refinanced DFIs. However, post-liberalization, DFIs have had to raise money from the market through bond offerings in the capital market and through private placements. DFIs also benefit from permissions to issue tax-free bonds.

The long gestation of infrastructure projects means that they require long-term capital. Such capital is typically supplied by pension and provident funds, insurers, post-office savings, and other long-term savings sources. The DFIs could even float sector-specific funds that would attract investors. They also access long-term credit from multilateral development institutions.

Further, these funds can also come from either internal or external sources. Recently established institutions like the NIIF have sought to raise capital from sovereign wealth funds, pension funds, and insurers. For external financing to be sustainable, the expenditures or revenues, ideally both, have to be in foreign currency. This would help avoid currency mismatches that happen when revenues of the foreign currency financed investment are in the local currency. Infrastructure projects, with local currency revenues, are therefore best financed by local currency debt.

DFIs can have a specific sectoral or broad focus. The specific sector ones typically cover infrastructure, core industries, small and medium enterprises, agriculture, and exports. Broadly focused ones tend to cover some or all of these sectors. Each of these activities has its unique financing requirements – use of funds, the tenor of funding, amounts involved, etc. The nature of these activities also determines the source of funding for these DFIs themselves.

DFIs can both take equity in the project or provide debt. Equity investments by DFIs could de-risk investments for private investors besides lowering the cost of capital of privately raised debt. On a related note, they can also be under-writers for equity raising.

The refinance role is most often a very stable source of income and invariably this part of the DFI balance sheet that could also off-set the losses on the direct lending side. Most often, the positive glow of profitability on DFI balance sheets can be traced to the dominance of refinancing activities and lending to captive government borrowers.

Gulzar Natarajan is an IAS Officer. Views expressed are personal.

This is the sixth article in a multi-part article series on infrastructure financing and the challenges associated with the sector. Read the first part here, second part here, third part here, fourth part here, and the fifth part here