The concept of a Wholesale and Long Term Finance (WLTF) bank is part of the scheme of differentiated banks that has been in the news of late. The creation of payments and small banks was also part of this agenda. One is not sure if these banks will make a major difference, but those promoting the same evidently have their plans in place. A corollary in the success of these banks would be that commercial banks have not been successful in spreading financial inclusion and have not harnessed use of technology. In fact, the regional rural banks and structure of cooperative banks have to be critically analysed in this context as they have not delivered.
Now, the WLTF bank concept is not really a new one as there was the rather strong and convincing structure of the Development Financial Institutions (DFIs) that existed from the 1950s to the beginning of the 21st century. The 3 institutions, IFCI, ICICI and IDBI, can be credited with building India by providing long-term finance to industry. The system was straight-forward, one where they were able to get funds at concessional rates and on-lend to industry. With the onset of financial liberalisation, this relation was severed and they had to borrow at market rates. This also meant that their lending rates had to be increased and the model ceased to be viable.
The result was that these DFIs got themselves converted to universal banks under much fanfare and both ICICI and IDBI became banks through reverse mergers with their commercial banks outfits. The main advantage was that they got access to current and savings deposits which account for around 35% of total deposits; that helped lower the cost of funds. But, given the structures of assets and liabilities, there were bound to be tenure mismatches when lending to infra projects or long-term projects.
More recently, IDFC has gotten converted to a commercial bank, and IFCI, too, is keen on doing the same. Quite clearly, it does appear that the era of DFIs is on the way out and those that remain are EXIM, NHB, NABARD and SIDBI, which are actually refinancing organisations. How do WLTF banks fit in now?
The purpose is to provide long-term finance exclusively to corporates, including infra companies and SMEs. These banks will do only wholesale lending, keeping retail loans to the minimum. Funding cannot be through regular deposits, but it is mentioned that there can be current deposits besides term-deposits of high value. They can issue bonds and can also subscribe to the same which are issued by corporates and hence play the role of market makers. They can also go in for borrowings from banks, CDs or securitisation etc.
Do we require such banks? The answer is “yes” as the present system cannot quite handle the demand for such funds. Commercial banks, including PSBs, have preferred to lend to the retail segment where the delinquency rates are low. Therefore, having banks which focus on only long-term lending will be very useful and add a new dimension to lending as banks continue to focus on short-term lending.
Will a public purpose be fulfilled in case WLTF banks come in? The answer again is “yes” as these banks will fill the gaps that exist in the system today. The demand for funds is high, given investment rate is quite low at 27% . If it has to be pushed up to 35%, alternative avenues need to be sourced as banks, ECBs and the debt market have their limitations. This new genre of banks will definitely add value.
How viable will they be? Once the WLTF matches the tenures of its assets with liabilities, there will be a good fit between the two. At present, AAA-rated bonds come with a rate of between 8-9% with the lower-end being reserved for public-sector companies. AA-rated bonds can range between 9-12%, while a higher rate has to be paid in case the rating is in the A category. Therefore, WLTF banks will need to get a very good rating to get a borrowing rate of 8-9%.
The banking system operates with high spreads between deposit and lending rates. Today, the spread between the base rate and one-year deposit rate is 275 bps. In FY16, the difference between cost of deposits and return on advances was 330 bps. Cost of funds was around 6%. With WLTF banks procuring funds at 300 bps higher than the banks, adding 330 bps spread will push up costs for the borrower. Will companies be willing to pay this much, especially when they can borrow directly from the market?
For WLTF banks to succeed, several options need to be explored. The first issue is how to lower the spreads for the WLTF bonds. Having bricks-and-mortar structures would add to costs and hence the option of being primarily an internet based bank can be considered. Second, the WLTF banks can be made to apportion lending activity across both credit and debt markets. A 50-50 division will be useful as they can lend directly in the bond market for bonds which will be higher-rated. This will also be the preferred route for higher-rated companies. The balance lending should be based on collateral with insolvency laws in place. Also, RBI should focus simultaneously on credit enhancements to be provided by banks on such bonds which may be subscribed by the WLTFs.
Third, the WLTF banks should be freed completely from CRR and SLR obligations. The CRR is a disincentive while SLR will make them gravitate towards G-Secs. Fourth, RBI can set tenures for their lending, i.e., not less than five years or such a norm, but should give the freedom to lend to any sector. Bringing in priority-sector-like norms will impede their activity.
It should be remembered that WLTF will be starting with the handicap of lending to the non-retail segment and taking on higher risk as these loans would be of a long tenure. Focusing on infra projects and term-lending makes FIs more vulnerable to NPAs and hence, prima facie, the last decadal developments are a dampener. In short, there should few inhibiting clauses in the terms of engagement for these banks, or else potential promoters would be at a disadvantage. An issue which should be kept in mind while giving permission is that all banks—including private sector—ones have faltered on asset quality when such long-term lending is concerned. How can one be sure the story is not repeated here?
WLTF banks could be a useful way of channelling funds to the sectors that can’t be handled by commercial banks. But given the past history of FIs, it will be interesting to observe the interest that may be shown by the players. Integrating this concept with the objective of developing the bond market will be possible, and should be pursued. Ultimately, any player who chooses to enter the fray would work around the financial viability of such projects before making an application. The pitfalls in the earlier dispensation of DFIs need to be addressed in detail by the applicants to reassure the central bank that these models can work.