In today’s Finshots, we tell you about the RBI’s (Reserve Bank of India’s) new rules for big infrastructure loans and why it has put banks and NBFCs (Non Banking Financial Companies) in a spot of bother.

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The Story

If you’re an avid follower of financial news or a Finshots regular, you probably know that India’s central bank, the RBI, has been tightening the noose around bank lending. It doesn’t want them to go on a lending spree and pile up hoards of risky loans that they may not be able to recover in the future.

That’s exactly why it has pulled another rabbit out of the hat. A couple of days ago, it sent shivers down the spines of banks and NBFCs (Non Banking Financial Companies) by telling them that they may have to set aside a higher percentage of project finance loans as provisions.

And if all of this just sounded alien to you, let’s explain.

Look, banks lend to different types of customers. You have the smaller retail loans that go out to customers like you and me. If these loans are secured, you offer an asset like a home or other property as security, take a loan on the basis of how much your assets are worth and start repaying in EMIs (Equated Monthly Instalments) almost as soon as the first loan disbursement clinks in your bank account.

Then there are these other kinds of loans. The bigger ones worth hundreds of crores of rupees. They could include loans to big corporations for building roads, bridges, ports, dams, airports, railway, telecommunication systems and other such large infrastructure projects.

And while they also get their loans on the basis of the value of the project, there are some added elements too.

See, completing these infrastructure projects can take a lot of time before they generate any real income. So the lender has to figure out when that could possibly happen and the amount of income the project can generate when it’s ready to begin business.

Only then can it decide the amount of the loan and the interest rate it can offer. Because if the project stalls or gets called off, banks will be left holding the bag. So yeah, loans like these are called project finance loans and their repayments only begin when the real operations begin.

Now, because lending is a risky business, banks often set aside a certain percentage of these loans out of their profits as a provision to help absorb the shocks of doubtful or bad debts in the future. You know, those that may have minimal or no chances of getting repaid. And with project loans, banks normally like to keep it at 0.4% of the loans they give out, because that’s what the RBI rule book says.

But the RBI wants to change that now. It feels that banks must think of setting aside up to 5% of these big project loans. It doesn’t matter if these infrastructure projects are promising and seem to get repaid just right. The RBI simply wants lenders to be on the safer side of things. And that has gotten banks going berserk.

Why, you ask?

Okay, the obvious bit is that these provisions are made out of profits that banks and NBFCs earn. So higher provisions will mean lower profits. And that could pressurise banks to earn these profits from other assets or increase the loans they lend. If they don’t, then they could infuriate shareholders who’ve already dragged many public and private bank stocks down by as much as 9%, after the RBI decided to crack the whip.

Banks could also try a different way to make up for the higher provisions. They could say “Hey, higher provisions mean higher costs. So let’s just pass on some of that burden to borrowers to keep our profit expectations intact.” This means that they’ll push interest rates up and project loans could be at least 1-1.5% more expensive. But that isn’t a foolproof way to protect a bank’s profitability because higher interest rates could pour cold water on borrowers’ enthusiasm too. And project loans could slide, dragging down profits with it.

That has probably got you thinking that a move like this could hurt the growth of infrastructure in the country. After all, the government has increased its allocation to infrastructure by 11% to ₹11 lakh crores in its interim budget for FY25. And it has an ambitious target of making India a developed economy by 2047, which means infrastructural growth is key. If corporations are tight on funds, it could derail this dream.

And it’s not as if bad loans are soaring at banks. If anything, they’re coming down. To put things into perspective, the gross NPAs (Non Performing Assets or just a technical term for bad loans) at banks were at a decadal low of 3.2% as of September 2023.

So then why is the RBI clamping down on project loan lending?

Okay, we can’t speak for the central bank. But if you put yourself in its shoes, you’ll probably realise that it's being mindful or taking cues from the past.

As much as a decade ago, Indian banks were reeling under the pressure of their own actions.

They aggressively lent to sectors like infrastructure despite knowing that these projects don’t always go as expected. They can encounter cost overruns or even run into regulatory troubles when they need licences and permissions. That can push project completion deadlines and affect loan repayments.

But despite that, banks slashed interest rates and stretched repayment periods of these borrowers so that they didn’t have to make provisions which would bring down their profitability.

The end result?

Loans to the infrastructure sector made up for nearly 52% of the total stressed loans of all scheduled banks. And the gross NPAs of public sector banks quadrupled between 2010 and 2014.

And it took years for the central bank to try to clean up things and bring banks back on track. And that’s probably what the RBI wants to avoid, even if things look pretty good right now.

But yeah, these are still draft rules. And banks already seem to be ready with their bargains to lower the provisions the RBI has recommended. Will they win over the hawk-eyed central bank? We’ll only have to wait and see.

Until then…

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