New RBI Regulation Causes Concern Among Banks

The Reserve Bank of India (RBI) is once again at the forefront of regulatory changes, this time introducing measures that have unsettled both banks and Non-Banking Financial Companies (NBFCs).

The central bank’s latest directive involves potentially increasing the provisions that banks must set aside for project finance loans, particularly those involving large-scale infrastructure projects. This move has sparked a wave of concern across the financial sector due to its implications on profitability and lending practices.

Understanding the Basics of Project Finance Loans

Before delving deeper into the new regulations, it’s essential to understand what project finance loans are. These are loans extended to fund large infrastructure ventures such as roads, bridges, ports, dams, airports, railways, and telecommunication systems. Unlike smaller retail loans, which are secured by assets and repaid in Equated Monthly Installments (EMIs), project finance loans are predicated on the project’s future revenue.

These loans are inherently risky because revenue generation only begins once the project is operational. Delays, cancellations, or other complications can lead to significant financial losses for lenders. To mitigate these risks, banks typically allocate a portion of their profits — as per RBI guidelines, currently 0.4% of the loans issued — to cover potential bad debts.

The Shift in RBI’s Approach

The RBI’s recent proposal suggests a substantial increase in this safety net, recommending that banks set aside up to 5% of their loans for major infrastructure projects. This precaution is intended to bolster lenders’ financial stability, but it has ruffled feathers within the banking community.

The increased provisions would be deducted from the bank’s earnings, reducing profits. This reduction could force banks to seek higher returns from other assets or expand their lending activities, potentially causing dissatisfaction among shareholders. In response to the regulatory change, the stock values of many banks have plummeted by up to 9%.

Potential Consequences and Strategies

In reaction to the higher provisioning requirement, banks might pass some of the increased costs onto borrowers by raising interest rates on project loans by 1-1.5%. While this could help maintain profit margins, it also risks reducing the number of project loans, impacting overall bank profitability.

This situation presents a dilemma: On one hand, the government is increasing its infrastructure budget by 11% to ₹11 lakh crores in FY25, signalling a commitment to make India a developed nation by 2047. On the other hand, if businesses face financial constraints due to higher loan costs, this vision could be jeopardised.

Historical Lessons and Current Trends

A look back at the last decade reveals why the RBI might be taking these precautionary measures. Indian banks previously suffered from policies that led to excessive lending to sectors like infrastructure despite the high risks of project delays and cost overruns.

Non-Performing Assets (NPAs) in the infrastructure sector in India have been a significant concern due to their disproportionate size compared to other sectors. This has been particularly evident in the power and road sectors, historically accounting for most banks’ total exposure to infrastructure project financing. The gross NPAs in this sector were about 8% of the total advances to the sector and accounted for nearly 13% of the NPAs in the banking sector by 2016.

Efforts to manage and reduce NPAs have included various legal, financial, and policy-level reforms. Notable among these are the SARFAESI Act of 2002, which allows banks to recover their NPAs without court involvement, and the Insolvency and Bankruptcy Code Act of 2016, aimed at consolidating and amending the laws relating to reorganisation and insolvency resolution in a time-bound manner.

Despite these efforts, the sector has seen significant failures, particularly in the power generation projects. For instance, recovery from insolvency resolutions in this sector has been disappointing, with banks recovering only around 28.9% on average from such resolutions. This low recovery rate underlines the systemic issues and the need for more effective risk mitigation and project financing strategies.

Banks often reduced interest rates and extended repayment periods for these high-risk borrowers to avoid making provisions that would lower profitability.

This strategy resulted in infrastructure loans accounting for about 52% of the total stressed loans across all scheduled banks, with the gross NPAs of public sector banks quadrupling from 2010 to 2014. It took years for the RBI to initiate a cleanup process to steer the banks back on course—a situation the RBI is likely keen to prevent from reoccurring.

The Road Ahead

The regulations are still in the draft stage, and banks are gearing up to negotiate with the RBI to lower the proposed provisions. The outcome of these negotiations will significantly impact the banking sector and the broader economy.

In summary, while the RBI’s new regulations aim to safeguard the financial system, they also pose challenges for banks, borrowers, and the country’s infrastructure goals. The balance between financial stability and economic growth remains delicate, and the coming months will reveal how this balance is managed.

Until then, stakeholders across the sector will be closely watching the developments, hoping for a resolution that supports both the health of the banks and the broader economic ambitions of India.

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Disclaimer: This article has been written for educational purposes only. The securities quoted are only examples and not recommendations.