[Arshan is a student at Jindal Global Law School.]
The Reserve Bank of India (RBI) issued a set of draft directions on 3 May 2024, specifically targeting banks and financial institutions that lend to infrastructure projects. These guidelines are called the "Reserve Bank of India - Prudential Framework for Income Recognition, Asset Classification, and Provisioning pertaining to Advances - Projects Under Implementation, Directions 2024" (Directions). These Directions apply to a broad range of financial entities, including commercial banks, non-banking financial institutions, urban cooperative banks and other financial institutions. However, the release of these Directions has been met with strong opposition from market participants, who have concerns about the impact of these new rules on their operations.
Project finance involves the establishment of a new special purpose vehicle (SPV), often structured as a joint venture between the participating entities. This legal entity is created exclusively to develop an infrastructure project, serving as a dedicated vehicle for its execution. The SPV raises funds through debt or equity, leveraging the anticipated future cash flows from the project itself, rather than relying on the creditworthiness of the parent entities.
The Directions were established to encompass the entire lifecycle of a project, from design through to operation. This introduced several new requirements for lenders, including, among others, a board-approved policy for resolving stressed project finance assets, continuous monitoring of the project’s net present value to ensure profitability, provisioning for non-stressed assets, and the creation and maintenance of project-specific databases.
How Will the Directions Affect Lenders?
Increased provisioning
The central concern with these guidelines is that it will increase the provisioning requirements (money to be set aside) to be maintained by lenders. During an infrastructure project’s construction phase, lenders would be required to provision 5% of the funded amount (money raised) as per paragraph M.33 of the Directions. Once the project reaches its operation phase i.e. when it begins generating cash flow the lenders are entitled to reduce this provisioned amount to 2.5% of the funded amount. Further reduction to just 1% of the funded amount is possible if the project generates enough cashflows to cover all repayment obligations and if its long-term debt is on a downward trajectory by at least by 20% from the time of achieving Date of Commencement of Commercial Operations as per paragraph M.34 of the Directions. This marks a stark increase over the existing provisioning requirement of the 0.4% as per the Master Circular - Prudential Norms on Income Recognition, Asset Classification and Provisioning Pertaining to Advances.
The increased provisioning requirements compel banks to allocate additional capital when financing infrastructure projects. Once implemented, these draft directions could significantly affect lenders' profits. The ripple effect may extend to capital expenditure and infrastructure development, as banks may become more selective in financing such projects, leading to tighter credit conditions and higher lending rates. Consequently, the increased cost of borrowing could render some projects financially unfeasible. The brunt of the impact would be felt by real estate companies, engineering-procurement-construction projects and public-private partnership projects (PPP).
Beyond the direct financial impact, many lenders may view the increased provisioning requirements as excessive, leading to higher costs and potentially dampening infrastructure developers' bidding appetite in the medium term. A key issue is that the Directions fail to differentiate between various project models, such as the hybrid annuity model (HAM), toll roads, or solar projects, each of which carries significantly different risks. By adopting a higher calculation for the probability of default, the RBI places sectors like renewable energy—already operating on thin profit margins and heavily reliant on debt financing—at a distinct disadvantage. In contrast, toll roads managed by private sector participants and HAM projects involving the National Highways Authority of India inherently carry lower risks, yet are subjected to the same stringent requirements.
Date of Commencement related concerns
Another issue that will severely affect lenders is surrounding the Date of Commencement of Commercial Operations (DCCO). Should there be a default or if the lenders need an extension on the initial DCCO of the project or any further extension of any amended DCCO, or if there is a need for infusion of any additional debt or diminution of the net present value occurs then this would trigger obligations under the draft Directions as these events would be classified as a “Credit Event”. Here there would be a review of the entire account required within 30 days from the occurrence of the trigger event. Along with that implementation of a resolution plan within 180 days after the end of the resolution period. Thereby creating a timebound manner in which a resolution plan has to be made to address these credit events. Upon implementation of the directions, lenders would be placed under additional stress as this would increase the monitoring requirements for them as well as other stakeholders.
Moreover, unlike the current infrastructure project regime, where DCCO deferment—including litigation—was permitted for up to 4 years (or 3 years for reasons beyond the control of lenders and developers), the draft Directions restrict this deferment to only 3 years. This modification could lead to the reclassification of exposures from the lender’s perspective, necessitating an increase in borrowing costs during project implementation, particularly in cases where litigation requires a longer resolution period.
Conditions for financial closure
The draft Directions also impose stringent conditions for achieving financial closure in projects under the PPP model. They require that at least 50% of the land be unencumbered and available, along with the necessary environmental clearances. In concession agreements for road projects under the PPP model, the DCCO can only be declared once 80% of the land has been provided to the developer by the appropriate authority, thereby mitigating the risk related to land availability. However, in general construction projects, the availability of land and environmental approvals typically serves as a pre-disbursement condition for a loan. Shifting this requirement to the pre-sanction stage could delay financial closure, thereby increasing the burden on both lenders and developers.
Intention of the RBI
Infrastructure projects are inherently complex, involving long gestation periods, multiple stakeholders, and substantial capital investment. These factors introduce a variety of risks that can create a cascading effect, regardless of whether the projects are managed by private companies or funded by the government. While government-backed projects are generally perceived to have lower risk, they are not immune to challenges. In fact, as of March 2024, approximately 42% of the government’s ongoing projects have experienced delays, and 24% have faced cost overruns.
The risks associated with infrastructure projects can be broadly categorized into project-specific risks, macroeconomic risks, and political and regulatory risks. Project-specific risks include delays and cost overruns, which can severely impact the project’s viability. Macroeconomic risks, such as the availability of financing and fluctuations in interest rates, also play a critical role in the success or failure of these projects. Additionally, political and regulatory risks, which encompass changes in laws or government policies, can further complicate the situation.
The failure of such projects can have significant economic consequences. India has already experienced a similar scenario during the twin balance sheet crisis, where excessive lending by banks to firms in capital-intensive sectors like infrastructure and power led to a surge in non-performing assets (NPAs). This situation arose because the firms were unable to generate the expected returns, thereby jeopardizing the stability of the financial system.
These draft Directions have been designed to improve long-term outcomes by empowering lenders to conduct more responsible due diligence. By increasing the lenders' financial commitment, these guidelines aim to enhance project preparation, monitoring, and management. This hands-on approach is expected to reduce risks associated with construction delays and cost overruns, ultimately leading to fewer project failures and a lower likelihood of projects being classified as NPAs.
The RBI has drafted these stringent prudential requirements to avoid a repeat of the twin balance sheet crisis. While these measures may place a financial burden on lenders, they are intended to safeguard the financial system by ensuring that infrastructure projects are better planned and executed. This way, the RBI aims to foster a more resilient and sustainable lending environment, ultimately protecting the economy from similar crises in the future.
Resolution Possibilities
To ease the impact on lenders’ profit margins, the new norms could be introduced gradually over a 3-year period. Instead of requiring an immediate 5% provision for projects in the construction phase, the provisioning requirements will be phased in. Specifically, lenders would need to set aside 2% in the fiscal year 2025, 3.5% in the fiscal year 2026, and reach the full 5% provision by the fiscal year 2027.
This staggered approach will give project finance lenders ample time to adjust to the new requirements without significantly disrupting their funding capabilities. By allowing a gradual transition, the shift from the current to the proposed regulatory framework can be managed more smoothly, ensuring that lenders can maintain their financial stability while adapting to the new provisions.
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