RBI's Project Financing Guidelines For Banks: Risk Vs Exuberance Before Capex Surge

The proposed guidelines advocate for a phased provision of 5 per cent for standard assets during the construction phase, with subsequent reductions to 2.5 per cent and 1 per cent of the funded outstanding upon project operationalisation.

These reductions are contingent upon the project's ability to maintain a positive net operating cash flow covering current repayment obligations to all lenders. Depending on the size of the loan book, this transition could result in an additional provisioning of 0.5 per cent to 3 per cent of a bank's net worth.

The proposals have had the banking industry up in arms. The arguments range from the move pushing back infrastructure projects to increasing their cost.

The reality is that the impact, whatever it may be, would only be short-term since infrastructure projects don’t wait to take off just because of risk provisioning norms. It may simply nudge out the smaller players and “I-also-finance-projects” players—a good sign for the finance sector's health.

Project finance, as outlined in the guidelines, involves funding methodologies wherein lenders primarily rely on revenues generated by a single project for loan repayment and security.

Typically associated with large-scale, complex installations such as power plants, EV platforms, chemical industries, and transportation infrastructure, this financing model necessitates detailed hands-on risk assessment and mitigation strategies, all through the project cycle.

With project completion timelines averaging 5-8 years, this new rule might make banks bear a provisioning burden ranging between 2.5 to 5 per cent of the loan amount during this phase. This is expected to have impact on the financials of both the banks and projects, particularly if banks choose to fully pass on the increased provisioning costs.

But this regulatory proposal also brings an increased sense of risk management. In a move to enhance risk management, banks are mandated to conduct annual project assessments, even during the construction phase. As of now, project financing does not entail continuously assessing and providing for any delays or project execution risks in the balance sheet.

With this new proposal, should changes occur in projected cash flows or the estimated project lifespan, lenders must allocate necessary provisions accordingly. While this is pragmatic, the industry worry is that the rules of the game should not change mid-game.

The banking sector, however, is one where the rules can and will change to ensure overall market stability and national economic sovereignty, than just look at bank profitability for the next few quarters.

NPA Worries Abate

The escalation of provision norms finds its roots in the exponential rise of non-performing assets (NPAs) witnessed over the past decade, notably due to the deterioration of numerous infrastructure loans. While gross NPAs soared to 11.8 per cent of gross advances by March 2018, they have since abated to 3.2 per cent as of September 2023.

Also, looking at the annual results of some banks, it looks like the Indian banking sector is at its all time best health. This defeats all theories about RBI’s fears of the Indian infrastructure sector mirroring the recent Chinese realty bubble story.

Capital Preparedness For Banks

With banks currently boasting robust financial health, the present juncture presents an opportune moment to bolster provisions for future contingencies. With the expected return of the Modi government, further accelerated growth of infrastructure projects is expected, and hence this could be RBI’s way of building pragmatism into its banks’ balance sheets.

It surely will not ever want a return of the period of financial turmoil that Indian infrastructure and banking went through between 2008-14.

However, concerns have been raised by some banks regarding the heightened stress this new regulatory proposal can bring in and the potential impact on their business books, atleast in the short term. This could necessitate raising further capital, particularly for some of the public sector banks, which may seek intervention by the finance ministry for additional funding.

Once the new cabinet is in place, this could see a policy decision on any potential disinvestment or mergers within the public sector banks (PSBs). For those who have similar capital raising worries, this could be a signal to reduce exposure to infrasturcture financing.

Banks are expected to lobby both the RBI and the finance ministry in opposition to the increase in provisions, arguing that it could disrupt India's momentum as the fastest-growing major economy amidst global uncertainty. They could contend that elevated provisions for ongoing projects may inflate costs, potentially resulting in delays and an escalation of stressed loans.

This regulatory idea could have some grain of genesis to dissuade smaller banks from financing infrastructure projects. This, if effective, could foster a distinct competitive strategy within the Indian banking sector.

After all, the Indian banking sector has almost zero competitive differentiation amongst each other in terms of their product design. Every bank tries to copy and clone what others do, without considering their bank culture and risk involved.

Capex Cycle And Pragmatism

Only after so many years, there seems to be a new capital expenditure (capex) cycle appearing on the horizon for the private sector, as evidenced by the recent uptick in project loans sanctioned by lenders. One must admit the government has been the primary driver of economic expansion through a pronounced emphasis on front-loading capex for infrastructure development.

The Finance Minister's allocation of Rs 11.11 lakh crore towards capital expenditure for FY 2024-25 highlights the government's commitment to infrastructure development. Consequently, a majority of infrastructure projects are now government-driven or government-owned, translating to diminished default risk.

This context renders the proposed draft regulation less concerning. With India's pronounced focus on infrastructure projects, the RBI appears inclined to maintain a proactive stance, positioning itself ahead of the curve as a prudent measure.

The RBI’s apprehensions regarding project financing by banks hold merit and have the potential to bolster lenders' balance sheets while establishing counter-cyclical buffers. It might come in handy when the exuberance for infrastructure projects increases in the third term of the government. After all, much of corporate borrowings for these come from banks, and not from bond markets, but that’s a different story.

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The deadline for public and stakeholder feedback on these draft regulations is set for June 15, 2024, coinciding with the installation and settling down of the new Union Government. While the RBI holds its institutional independence, this timeline could facilitate alignment for PSBs with directives from their owner's representative, the Ministry of Finance.

The RBI may consider the concerns voiced by lenders, as well as government inputs, given the significant volume of ongoing projects, and may adjust provisioning norms accordingly to mitigate unintended consequences such as reluctance to lend for under-construction projects. One should also factor that at some point in next few quarters, RBI’s Monetary Policy Committee might increase the repo rates. This would make the cost of funding higher. 

As the saying goes, "Risk is not the absence of fear, but the courage to confront it in pursuit of progress." All in all, the RBI has clearly sounded its intent on what it wants to see in project financing—balancing growth with prudent risk management practices.

It is based on expectation of real-time adjustment in the balance sheet, and of risk factors to a project that is in the execution stage. Push comes to shove, this rule is bound to be made effective, either now organically, or at some stage through other policy designs.

(Srinath Sridharan is a Mumbai-based coporate advisor and policy researcher. Views expressed are personal)