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Endgame in sight?

Sanjiv Shankaran

THE end-game is in sight for Development Financial Institutions (DFIs). Adversely impacted by a large proportion of bad loans and a hostile environment, DFIs are heading towards extinction. At the moment, it is difficult to imagine DFIs lasting much longer.

DFIs, in the context of this article, refer only to all-Indian institutions, such as IDBI and IFCI that are geared towards long-term financing of projects. In terms of their evolution, size and skill, IDBI, IFCI and the erstwhile ICICI are unique. The ebb and flow of their business over the last few years reflect the challenges that confront the financial sector.

Pincer grip of NPAs and environment

Bad loans — usually referred to as Non-Performing Assets (NPAs) — are an overwhelming factor. The essence of DFIs' business is to borrow money and on-lend at a higher interest rate. Created primarily to lend long-term — in relation to banks — DFIs operate in the market segment more likely to be affected by a large change in the environment.

A change in environment, among other factors, led to a large number of loans made by DFIs in the mid-1990s. By March 2002, 11.7 per cent of IDBI's assets and 22.21 per cent of IFCI's assets were NPAs. In comparison, State Bank of India (SBI) and HDFC Bank reported an aggregate NPA level of 11.95 per cent and 1.96 per cent respectively, during the same period. IDBI's net NPAs (after deducting provisions and write-offs) as a proportion of equity shareholders' funds was far higher than that of SBI.

The high level of NPAs squeezes DFIs' income because assets that should be producing a return fail to do so. At the same time, money borrowed by DFIs has to be serviced.The cost of borrowing is a vital ingredient in DFIs' operation. Till the early 1990s, DFIs were granted concessional finance by the government because of their critical role in industrial development. Over the last decade, DFIs have been left largely to their own devices. Consequently, their borrowing has become more expensive.

Caught between the pincer-like movement of NPAs and higher borrowing cost, DFIs are in a predicament. Moreover, a difficult business environment for new manufacturing projects, combined with the elimination of subsidised funds has made it unviable to continue with the existing DFI model.

Looking for alternatives, DFIs have begun to lend short-term — about 63 per cent of IDBI's sanctions in 2001-02 were short-term. But short-term lending pits DFIs against banks that can access money at a lower cost. Thus, DFIs find themselves in a situation where their business model is of limited use. Alternatives have been brought into the realm of debate by the Government — the largest shareholder in DFIs — and the old business model seems headed for extinction.

Universal banking: One-stop solution

The erstwhile ICICI showed the way out last year by initiating a merger with a bank. As IDBI and IFCI increasingly look towards short-term lending, transformation into banks seems the best way to increase competitiveness. IDBI is likely to be the first to transform itself. Once the legal structure that governs IDBI changes, it opens the door for a merger with an existing bank.

IFCI's alarming financial situation is an additional obstacle to a merger with a healthy bank. In fiscal 2002, the company was unable to generate an operating income to meet its borrowing cost, let alone its running cost. The company's net loss for the year was Rs 884 crore.

IDBI's finances are in a better shape, thereby, making it a better candidate for a merger. IDBI Bank, promoted by IDBI, is one target. But reports suggest that IDBI Bank is reluctant to be swallowed by its promoter. Looking back at the run-up to ICICI's transformation, ICICI Bank was relatively more dominant than IDBI Bank is today.

That leaves a handful of nationalised banks as likely targets for a merger with IDBI. At the moment, it appears unlikely that nationalised banks would want to be eagerly embraced because of the fear that erstwhile IDBI personnel would be dominant in the universal bank.

Another difficulty IDBI faces is a Parliamentary approval to change its legal structure, and thereby, open the door to banking. At the current juncture, it is difficult to see Parliament reacting with alacrity to IDBI's dilemma, distracted as the parliamentarians are by other issues of far-reaching consequences.

IFCI's case is more complicated. The precarious state of the company — its capital adequacy in March 2002 was 3.12 per cent as against Reserve Bank's minimum requirement of 9 per cent — may prove a disadvantage in a restructuring exercise.

In any case, a consultant hired by IFCI suggested segregating its good assets that could eventually be merged with a potential universal bank. Mr V. P. Singh, Chairman and Managing Director, IFCI, has been quoted in the media as saying that IFCI is looking for a strategic partner for itself. At this juncture, the only conclusion investors can reach is that the Government is committed to bailing out IFCI.

To illustrate, last fiscal, IFCI received support from the Government in the form of 20-year convertible bonds worth Rs 400 crore. Government support was bolstered by LIC's 20-year convertible bonds of Rs 200 crore, a Rs 200-crore short-term loan from SBI and IDBI's sustenance by way of long-term bonds with a maturity value of Rs 200 crore.

The support may prove a source of comfort for IFCI's shareholders, but most them are likely to be clueless about its destination.

Asset reconstruction

One suggestion put forth by IFCI's consultant is that its NPAs could be segregated and transferred to an Asset Reconstruction Company (ARC) — dubbed bad bank strategy — for dedicated and focussed attention. IFCI established Assets Care Enterprise (ACE) recently. The exercise is yet to bear fruit because critical issues are not cut and dry. As long as grey areas surround the operation of ARCs, a definitive solution to IFCI's problems is unlikely to emerge.

Investment outlook

It is clear that NPAs and an unfavourable environment plague the DFIs. NPAs, in particular, have a bearing on the likelihood of DFIs' merger with banks. If the DFIs' cannot transform into banks, recovery seems unlikely. Shareholders of both DFIs, especially those who invested at the time of the public issue, may consider staying invested. Having weathered the worst phase, it may be prudent to stay invested when a recovery exercise is underway. The drawback with this move is that the Government may postpone tough decisions, thereby, allowing the problem to worsen. Yet, staying the course appears the least damaging option.

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