When the Reserve Bank of India launched the 5/25 scheme (officially called the Flexible Structuring of Long Term Project Loans to Infrastructure and Core Sector Industries) and subsequently extended it to existing project loans in addition to new loans there may have been a collective sigh of relief from bankers and corporates.
While judicious use and limited application of this scheme would be beneficial for funding the
infrastructure needs of India, indiscreet application of the scheme to most projects may create some problems in future. This article is an attempt to look at just how helpful this scheme may be in achieving its objective and discusses certain considerations one may have to ensure that loans under this scheme are not extended indiscreetly
Key features of 5/25: The ‘5/25’ moniker summarily refers to the feature that the loan will be repaid over a maximum period of 25 years. However, the banks will have to refinance the loan every 5 year.
As per this scheme, even though the loan will be refinanced after 5 to 7 years, while initially
underwriting the loan (Initial Debt Facility-IDF), the lenders will assume amortization period (ie; period over which the principal will be repaid) of 20-25 years. The portion of the principal which will remain unpaid at the end of 5-7 years will be refinanced (Refinancing Debt Facility-RDF). However, this amount to be refinanced needs to be stated upfront.
Higher ability to withstand downturns: The need to repay the entire project loan over a 8-12 year period, for an debt-financed capital intensive asset whose life is 25-30 years, itself may have been a factor contributing to the default of some of these loans.
The extended debt repayment period under ‘5/25’ scheme will allow the borrowers in long-gestation projects to better manage their cashflows, which are usually slim and uncertain in the first few years of most projects. The debt servicing requirement will be lower because of lower principal repayment per period. Thus the loan will be able to handle stress related to slowdown and shocks more comfortably, without being tagged as ‘restructured’ account. Banks will also be relieved of the burden of keeping extra provisions associated with ‘restructured account’.
Regulatory Solution to an economic problem: Before the launch of 5/25 scheme, Indian banks would have found it virtually impossible to extend loans with repayment period of 20-25 year in any meaningful scale. To explain the issue at the cost of over-simplification, the loans which the banks extend are assets (since they generate income) in the banks’ balance sheet.
To be able to extend such loans the banks also have to borrow from the market/government/central bank and of course have to tap customer deposits. These are the liabilities of the bank. Now say, the bank has extended substantial amount of loans to be repaid over 20-25 years. While to fund such loans it has tapped customer deposits whose typical maturity is 2-3 years and itself borrowed from markets with maturity of 3-5 years. Then to service its liabilities the bank would have to repeatedly go out to generate more liabilities(deposits and borrowings) to service its existing liabilities. Such issues, often highlighted as asset-liability-management (ALM) issues, are not looked kindly by any banking regulator and investors.
ALM issues would have been reasonably addressed if the maturity period of the assets were broadly in line with maturity period of the liabilities. Since in that case, the monies earned from the assets would have been used to service the banks liabilities.
The 5/25 scheme formally accepts the problem of inherent ALM mismatch in infrastructure loans.
However, the ALM issue of a bank is a purely economic problem. A more structural solution of the problem would be to increase the weighted average tenure of banks’ liability to 10-15 years from the current 3 to 5 years. However, this cannot be done overnight.
Given these constraints in addressing the issue at a fundamental level, 5/25 provides a regulatory solution to what is essentially an economic problem. It is for this reason the banking system needs to be cautious. If too many big ticket 5/25 loans are sanctioned in a hurry, and these become ‘bad’ around the time of their refinancing which is 5-7 years from now, then the specter of stressed assets and ALM issues may again haunt the banks.
Checks and balances: For good reasons, the RBI has placed some checks and balances to reduce
chance if not eliminate chances of misuse of the scheme. As per this author’s interpretation, at the time of refinancing or for that matter changing the amortization schedule from the one mentioned in IDF, the loan should be a ‘standard’ loan and should not have been restructured in the past. The economic value of the loan to the bank as reflected by the measure- Net Present Value (NPV) should remain unchanged after this exercise.
Lenders should apply 5/25 scheme with discretion: The lenders will do well to try and take view on the company beyond the first refinancing date. As the default and transition study of major Indian rating agencies show even at an ‘A’ category rating level the default rate over a three-year period varies from 3% to well over 5%.
To explain, if there is a pool of 100 corporates who are currently rated ‘A’, it is likely that over 5 to 7 years period well over 5 of them may default. Now if the period of refinancing coincides with an economic slowdown and given that the 5/25 scheme is applicable to only core sectors, the default rate may be much higher. Thus banks may do well to apply 5/25 scheme to corporates or projects who in normal course have a high likelihood of survival over next 20-25 years, which is the life of the loan. At a bare minimum, banks should be reasonably confident that the companies who they are considering for 5/25 loans should survive at least till the first refinancing point.
Scope of ‘Extend & Pretend’: If hypothetically, certain lenders do ‘distribute’ the 5/25 scheme indiscriminately, the moment of truth will come at the time of first refinancing. If the corporate defaults, then the lenders will be stuck with the loan. So what should ideally have been restructured today may come up for restructuring 5-7 years down the line.
However, if the account remains ‘standard’ but figures in the list of SMA 1 (30 to 60 days loan
servicing delay) or SMA 2 (60 to 90 days loan servicing delay) around the time of refinancing, then there may be a scenario where the existing lenders would refinance and possibly re-draw the amortisation schedule and there by avoid the account from getting tagged as restructured or NPA. In a sense banks may be tempted to extend the refinancing facility and ‘pretend’ it is a standard asset.
RBI silent on promoter’s skin in the game: RBI is silent on requirements from the sponsor or equity holders in the project with respect to 5/25 scheme. It may not be difficult to find projects where the entire project is technically debt funded by Indian financial system. The sponsor’s contribution in such cases may have been funded by promoter borrowing against the pledge of shares of their holding company. Here the sponsor’s ‘true’ equity contribution is virtually zero. Now if the construction work is sub-contracted to a related party of the sponsor, then effectively the sponsor gets super normal return on minimal investment.
In addition, it may now happen that because of lesser amortisation, the projects may be able to
upstream dividend while the loans get refinanced. One may in future find cases where in the first 10-12 years the project sponsor, by virtue of the dividend received, got back the initial investment with good returns while the bank will have to keep on funding for the full 25 years.
RBI may have done well to put checks and balances to the extent that banks need to ascertain the true nature of the equity contribution of the promoter before the project is eligible for a 5/25 loan.
In addition, checks may be considered with respect to dividend up-streaming and related party
transaction at the project level. This is to prevent the residual stake holder (the equity holders) doesnot get back their investment ahead of the banks which have senior secured claim on the project cash flow.
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