CAN TAKE - OUT FINANCING TAKE OFF IN INDIA??

A Banking Perspective of Take-Out Financing

Submitted By: Misha Tyagi, MBA (2010-2012), NMIMS, Mumbai mishatyagi@gmail.com 9970286854 Aditi Kaikini, MBA (2010-2012), NMIMS, Mumbai aditi.kaikini@gmail.com 9833265671

The Infrastructure Sector is of strategic importance to any Country Because it drives Economic Growth!!! A robust infrastructure not only facilitates expansion of industry & trade, but also directly leads to job creation and a better standard of living. This in turns attracts further investment and growth. However, infrastructure projects are characterized by unique risk profiles that add to the complexity in planning & execution. These risks are --------: Long gestation period Huge financial requirements necessitating loan syndication Contractually Driven, Regulatory & Legal Framework Revenues tied to economic variables Environmental Concerns Infrastructure has these inherent risks which lead to time overruns and increase project costs, but real challenge lies in mobilizing funds for projects. Government had allocated 8.33% of GDP to this sector in 11th Five Year plan, and is likely to increase it to 10% of GDP in 12 th Plan. This displays Governments commitment to augment infrastructure capabilities in India. An increase in project order inflows indicates demand, but a paucity of long term funds has come in the way of execution. Thus, RBI has taken the onus to channelize funds towards infrastructure, where it is a win- win situation for the project company and the financier. In 2004, it allowed banks to borrow from long term sources to fulfill long term project needs. However, at that time, the banks were hesitant to take such long term borrowing obligations and continued with short term borrowing. Whereas, infrastructure long term loans increased as a % of total loans. This gave rise to an acute problem known as Asset Liability Mismatch. This is the underlying principle of what we call as Take - Out Financing. What is Take Out Financing?? RBI established IIFCL for providing long term financial assistance to infrastructure projects. This SPV was used in the product design of Take -Out Financing, where long duration projects would be financed by medium term loans. Under this, bank would take

the loan out from its balance sheet and sell it to IIFCL or IDFC. Thus, this allows lending banks to bridge the time difference & match their assets-liabilities. These government owned entities - IIFCL and IDFC can procure long term funds from the market and hence are in a better position to fund the projects. This serves a dual purpose as project company gets access to long term funds and banking system can have a healthy balance sheet. Let us see an example: a corporate, which wants to borrow money for financing say an express highway, will approach a bank for say a 15 year loan. Bank will provide loan for 5 years and then approach IIFCL or IDFC to take over the loan from 6th to 15th year. Here, loan is transferred after the commercial operation date in 6th year. All parties enter into an agreement and the covenant is written for compliance of project milestones to avail this loan. Thus, there is a tripartite arrangement between Project Company, Bank and IIFCL/IDFC. However, bank is supposed to pay fees of upto 0.3% pa of the takeout amount to IIFCL. The taking-over institution can take-out the liability of lending bank on an Unconditional or Conditional basis: I. Unconditional take-out finance:

It involves assumption of partial/full credit risk by the taking over institution from the original lender. Original lender bears the credit facility in its books till it is taken over while the taking over institution reflects it as a contingent liability till it actually takes over. It is suitable for medium-sized banks which are unwilling to bear project risk due to their limited project appraisal skills. II. Conditional take-out finance:

Here, there is an element of uncertainty over transfer of assets to the taking over institution as it is subject to certain project-performance-linked conditions to be satisfied by the borrower. The obligation to take-over the assets, though conditional needs to be reflected on the books of the taking over institution as a contingent liability. It is more suitable for banks which have adequate project appraisal skills BUT for the reasons of Asser-Liability mismatch and credit exposure constraints, would like to have the option to exit from project after a pre-determined period.

What is holding Take-out financing back?? The concept of Take out Financing is still very nascent in India. However, there are many reasons that are not allowing this product to grow to its full potential. RBIs exposure norms for risk capital provision, conservative attitude of Indian banks, the fees and costs of financing, the worthiness of the appraisal expertise of the taking over institution etc have all rendered the product ineffective in stimulating infrastructure finance. RBIs exposure norms implying that both the Lending institution and the Taking over institution must provide for the risk capital for the loans has rendered the product less desirable. Opportunistic behavior of lending banks: The attitude of the banks is such that they dont want to sell those assets which are paying high interest rate after the construction risk is over and want to transfer only potentially bad loans thereby affecting the quality of assets on IIFCLs balance sheet. While, banks are unwilling to sell those loans which are expected to meet their targets. Take out fees to be paid by lenders availing take-out finance somewhat reduces the attractiveness of this scheme. IIFCLs plan of doing away with this take-out fee is expected to stimulate greater exposure to long gestation period infrastructure projects; but the impact will be short-term as lending institutions have sectoral lending ceilings. IIFCL plans to reduce interest rate on the taken-out loan by 75-200 bps based on the revised risk profile of the project. But, majority of Indian infrastructure projects run behind their schedules which will make them ineligible to take advantage of this incentive. The lending banks are apprehensive about capabilities of the taking over institution for assessing different infrastructure projects. It is only the unconditional take-out financing which helps lending banks to resolve Asset-Liability mismatch. Under conditional financing, long-term risk of the project still remains on the books of banks until the take-out actually happens. Moreover, it is subjected to high uncertainties with respect to achievement of the project milestones at the end of five years, which in Indian infrastructure scenario, are more often unfulfilled than not.

So what next..? The RBIs exposure norms should be revised to improve the acceptance & penetration of this product. Certain changes should be incorporated to transfer risk at the pre construction phase where the risk is the highest. At this point of time, even if the product is priced higher, banks and participants may resort to this financing due to the high returns and mitigated risks. Another effort to have a buoyant infrastructure financing scheme, the finance ministry has established an Infrastructure Debt Fund (IDF) to invite participation of foreign funds and domestic insurance money into Indian infrastructure projects. Banks and NBFCs will set up either a mutual fund or another NBFC, which will sell either mutual fund (MF) units to foreign funds or insurance companies and raise money. However, the worthiness of this scheme lies in the ability to attract foreign investors. In India, foreign banks refrain from providing project finance due to the high risks involved in the project construction phase. So, in the present scenario, as compared to IDF, take out financing scheme is more attractive and can be further restructured to increase penetration.