The story so far: To strengthen the existing regulatory framework for long gestation period financing for projects such as infrastructure, non-infrastructure and commercial real estate sectors, the Reserve Bank of India (RBI) issued draft regulations for consultation earlier this month. The regulations endeavour to provide a “harmonised prudential framework” for financing projects. It also proposes to revise the criteria for changing the date of commencement of commercial operations (DCCO) of such projects. As per the banking regulator, this is in light of a review of the extant instructions and analysis of the risks inherent in such financing. Comments on the draft direction are solicited until June 15.  

What is the purpose of the project financing framework? 

Infrastructure projects usually have a long gestation period, with a higher probability of not being financially viable. It may not always be possible to meet investment requirements of the projects fully from the budgetary resources of the government. This opens up two financing avenues: public private partnerships and project financing from domestic financial institutions. The latter is particularly crucial for certain projects with longer payback periods. Depending on scale and technology, these projects may also require a loan with a longer tenure. 

Such projects may face multiple obstacles leading to delays or cost-overruns. For perspective, the Ministry of Statistics and Programme Implementation’s March review of 1,837 projects observed that 779 of them were delayed and 449 faced cost overruns. Cost overruns stood at ₹5.01 lakh crores when compared with their original cost. The review attributed the delay to land acquisition, obtaining forest/environment clearances, changes in scope (and size), and delays in tendering, ordering and obtaining equipment, among other things. Cost overruns were primarily due to under-estimation of original cost, high cost of environmental safeguards and rehabilitation measures for those displaced and spiralling land acquisition costs.  

These factors are dampeners for banks, which would have priced the risks associated with the project in a certain way on their books. As explained by the then Deputy Governor of RBI, Harun R. Khan (2012), “The added uncertainty due to these factors (legal and procedural) affects the risk appetite of investors as well as banks to extend funds for the development of infrastructure.”  

What are the more important revisions? 

RBI’s focus is on mitigating a ‘credit event,’ that is, a default or a need to extend the original DCCO or infuse additional debt, and/or diminution in the net present value (NPV) of the project.  

One of the more important revisions concerns ‘provisioning,’ that is, setting aside some money ahead of time to compensate for a potential loss. The proposed framework recommends that, at the construction stage (that is, when the financial assessment is finalised and before commencement), a general provision of 5% is to be maintained on all existing and fresh exposures. This is a revision from the erstwhile 0.4%. Concerns have emerged about the impact on the cost of debt. According to CareEdge Ratings, this would “dampen the bidding appetite from infrastructure developers in the medium term.” This 5% provisioning would be implemented in a phased manner, that is, 2% for FY25, 3.5% for the next financial year and eventually 5% in FY27. 

The framework stipulates that the provisioning can be reduced to 2.5% and 1% at the operational phase (that is, commencement of commercial operations). For the latter, the project must have a positive net operating cash flow to cover all repayment obligations and total long-term debt must have declined by at least 20% from the outstanding when the DCCO is achieved.  

“Projects with stable cash flows, like road annuities, transmission and commercial real estate, typically see an improvement in credit profile within one year of establishing a payment track record from the counterparty. Therefore, the mandate could delay the realisation of interest rate benefits for such projects, despite an enhanced credit profile,” CareEdge states in its report. It is important to note that, being capital intensive, infrastructure projects are sensitive to interest rates. However, it adds, the move would address “risks associated with bulky back-ended repayments and subsequent refinancing.” 

Does the framework introduce prudential conditions for financing projects?  

The framework seeks that all mandatory pre-requisites must be in place before the financial year’s closure (thus, before the finalising of a financial statement). The indicative list must provide environmental, regulatory and legal clearances relevant to the project. It is only for PPP projects that the framework proposes to accept half of the stipulated land availability for financial closure.  

The DCCO must be clearly spelt out. Financial disbursals would be made and the progress in equity infusion agreed to based on the stages of completion. For PPP projects, the disbursal should begin only after the de facto handing over of a contract letter to the developer. The onus is on the bank to deploy an independent engineer or architect who would be responsible for certifying the project’s progress.  

RBI proposes to mandate that a positive Net Present Value (NPV) be a prerequisite to obtain project finance. It also seeks that lenders get the project NPV independently re-evaluated every year. This is to help them avert the possibility of any build-up of stress and have an action plan in place.  

Does the framework provide scope to revise repayment norms?  

Yes. However, the framework proposes that the original or revised repayment tenure, inclusive of the moratorium period, must not exceed 85% of the economic life of the project.  

RBI’s proposed framework also recommends certain criteria for evaluating a change in repayment schedule due to an increase in the project outlay if there’s an increase in scope and size of the project. This revision will have to take place before commencement of commercial operations, after lenders offer a satisfactory re-assessment about the viability of the project, and if the risk in project cost, excluding any cost overrun, is 25% or more of the original outlay. Cost overruns happen when expenditures exceed the budgeted project outlay, whereas increase in costs refers to the difference between the original budget and the final cost at completion.  

Significantly, the framework also introduces guidelines to trigger a standby credit facility. This is to be sanctioned at the time of financial closure to fund overruns arising due to delays. The framework stipulates an incremental funding of 10% of the original project cost.  

What have initial observations been?  

The ongoing impact assessment is ascertaining potential impacts on banks’ profitability, risk appetite for future project financing and a rise in credit costs. 

Ratings agency ICRA observed in a report that higher provisioning requirement for projects under implementation would impact the profitability of non-banking financial companies (and infrastructure financing companies), though the impact would be spread across a three-year period. ICRA also said it estimates funding costs could go up by 20-40 basis points (bps) in some cases. This is because lenders would look to build an additional risk premium when pricing their loans.

In their recent earnings call, three state-owned lenders— State Bank of India (SBI), Union Bank of India and Bank of Baroda (BoB)— expressed confidence in the proposal not having any “significant” impact. However, SBI Chairman Dinesh Kumar Khara indicated that pricing of loans may have to be revisited. Mr. Khara also mentioned that RBI’s concern could be about the “right pricing of risk by some lenders,” especially those of long tenures, say 15 years.

BoB CEO Devdutt Chand indicated that credit costs will not go up “significantly”– potentially “a couple of” points below 10 bps only.