Prudential Norms and Peculiarity of Road Projects

“The provision made by RBI to consider the special rights provided under concession agreement to lenders making the loan as secured lending are important and lenders have to ensure that these critical rights are available to them while considering financing of PPP road projects.”

As per the RBI guidelines, banks classify their advances as secured and unsecured. RBI defines an advance unsecured when realisable value of security is not more than 10 per cent of outstanding advance. Here, the security is defined as tangible security which does not include intangible like guarantee, comfort letters etc. When an unsecured advance turns NPA, the bank has to make additional provisioning (as compared to a secured NPA advance) of 10 percent at the initial stage of Sub-Standard classification and which increases to 100% when the asset class deteriorates to Doubtful categories.

In the above background financing of road infrastructure projects appears to be an interesting subject. Most of the road infrastructure projects are floated by NHAI or State level agencies under Public Private Partnership (PPP) model. These projects are based on competitive bidding under various models like BOT, DBFOT, ANNUITY, HAM, OMT etc. The projects are awarded for long term concession period generally ranging from 15 to 30 years by way of Concession Agreement under which concessionaire gets the rights to use all the project assets during concession period.

Generally when capital intensive projects are developed, tangible assets are created and which are provided as security to the project financing banks. However, in road projects the developer is provided a long term concession period to construct the road and maintain & manage it during the concession period. At the end of the period, the assets revert to the project authority. Hence, a peculiar situation arise where no major tangible assets rests with the project developers which can be auctioned by lenders to recover their loans in case of default by the developer in repayment of loans granted for construction of the road project. In these projects, there are no project assets which can be mortgaged to the bank. In order to safeguard interest of lenders, necessary provisions are made in the Concession Agreement that allows substitution of project concessionaire by banks in case of default under the financing documents. The Concession Agreement allows banks rights to receive annuities/toll collection from the assets, and which can be hypothecated/assigned along with others rights, movable assets and current assets.

RBI guidelines provide that in such PPP projects, the advances can be considered as secured to the extent assured by the project authority in terms of the Concession Agreement, subject to the following conditions:

a) User charges/toll/tariff payments are kept in an escrow account where senior lenders have priority over withdrawals by the concessionaire;

b) There is sufficient risk mitigation, such as pre-determined increase in user charges or increase in concession period, in case project revenues are lower than anticipated;

c) The lenders have a right of substitution in case of concessionaire default;

d) The lenders have a right to trigger termination in case of default in debt service; and

e) Upon termination, the Project Authority has an obligation of (i) compulsory buy-out and (ii) repayment of debt due in a pre-determined manner.

In all such cases, banks must satisfy themselves about the legal enforceability of the provisions of the tripartite agreement and factor in their past experience with such contracts.

India has second largest road networks in the World. The Govt.  of India has target to construct 65000 Km of National Highways by year 2022 at the investment of Rs.5.35 lakh crore. The Govt. has stated to boost corporate investment in road and infrastructure sector projects and encouraging banks/FIs/FDIs for supporting the sector. The recently introduced Hybrid Annuity (HAM) model of developing road projects has received good acceptance by developers as well lenders considering the grant upto 40 percent in the form of annuity payments of the project bid cost from NHAI during construction stage. The remaining 60 per cent is paid by NHAI after project completion based on maintenance performance & quality, in the form of semi annual annuities over the concession period. Therefore, the sector provides at attractive business opportunity for lenders. The provision made by RBI to consider the special rights provided under concession agreement to lenders making the loan as secured lending are important and lenders have to ensure that these critical rights are available to them while considering the PPP road financing projects.

Disclaimer: The views expressed in the article above are personal views of the author and should not be thought to represent official views, ideas, or policies of any agency or institution.

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A fresh lease of life to Trade Credits Business

The banking regular in India has issued revised framework on trade credits policy on March 13, 2019. Trade credits is kind of financing in foreign currency provided by foreign banks, financial institutions, supplier of goods, and other permitted lenders for import of capital and non capital goods in India. These include supplier’s credit and buyer’s credit from recognized lenders. Such financing can be also availed from foreign branches/subsidiaries of Indian banks. In fact, TCs have been one of the important business segments for them.

Trade credits have importance in India considering their benefit as low cost of finance as compared to high cost Rupee debt prevailing in the country. From WC finance angle, TCs have much wider impact on this front. Not only the costing but also depending on the operating cycle of the borrower, TCs have helped in managing cash flows to the companies.

TCs had came into negative news about an year back when the firms of diamond merchant misused the system and created a big scam forcing the regulator discontinuing (in fact exactly one year back on March 13, 2018 !) the LoU/LoC facility from Indian banks for supporting the TCs.  LoUc/LoCs are the kind of foreign bank guarantees extended by Indian lenders in favour of overseas lenders providing the TCs. The comfort of such guarantees from Indian banks, made life easy for Indian firms in raising low cost financing in the form of TCs in quickest of time.

TCs can be availed for import of non capital goods and the tenor permissible is upto one year (three years for shipyards/ship builders) or operating cycle of the borrower, whichever is less. This has huge bearing on the Indian firms operating in globalized world having severe competition on cost and margin fronts. Before the ban on LoU/LoCs, Indian firms were considering the global markets for sourcing of raw materials due to availability of cheap TCs based on LoU/LoC support. The ban in March 2018 closed this door since without LoU/LoC it was not possible for most of the mid/small size Indian firms to avail TCs. 

The external debt of the country as on September 2018 reduced from USD 529 bn of March 2018 to USD 510 billion, of which USD 104 billion was related to short term trade credits. This reflects the magnitude TCs carry on Indian financial markets. Exports of the country in FY 2019 till January are estimated to be USD 440 bn against the imports of USD 531 bn during the same period. Therefore, the country needs to facilitate competitive global financing environment to its industries in order to achieve exports outpacing imports.

In a positive move, the regulator has also increased the limit under automatic route for availing TCs from USD 20 per transaction to USD 50 mn. In fact, the limit under automatic route has been substantially increased to USD 150 mn for specific sector viz.oil/gas refining & mining, airline and shipping companies. This is supportive action and will benefit industries in reducing the procedural time in availing TCs. Although regulator as reduced the ‘All In Cost’ ceiling from Benchmark rate plus 350 bps to Benchmark rate plus 250 which may make TCs less attractive to lenders. The maximum allowed period of TCs for capital goods has been also reduced from five years to three years.  

While TCs provide advantage of low cost of finance, these instruments are also like a double edge sword and can be detrimental if not handled aptly. These instruments carry foreign exchange risks. Many Indian firms have burnt their fingers in the past and some have been completely devastated by unhedged foreign currency exposures. The ECB guidelines also stipulate that firms raising TCs are required to follow the guidelines for hedging with a board approved risk management policy. Therefore, while regulator has reopened the TCBG gate, the borrowers will also need to be alert in managing unhedged risks.

It will take some time to see positive impact of regulator’s move on TCs since most of Indian lenders had cancelled the sanctioned BG lines for availing TCs post ban of March 2018. The lenders would need to reassess borrowers and sanction fresh lines for such TC BGs. Bearing the past mistakes and diamond merchant fiasco in mind, the lenders are expected to tread cautiously this time. Events like NBFC liquidity crisis, increasing defaults in loans against pledged shares etc. are keeping the mood of corporate lending market as sombre. However, over cautious approach under the shadow of high level of NPAs and diminishing confidence in external credit ratings would not be good for industries. The regulator has done its job for supporting industries, now its turn for lenders to believe in Confucius saying that our greatest glory is not in never falling, but in rising every time we fall. 

Disclaimer: The views expressed in the article above are personal views of the author and should not be thought to represent official views, ideas, or policies of any agency or institution.

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The Untold Story of PCA

Prompt Corrective Action (PCA) is a safeguarding framework applied by Reserve Bank of India (RBI) on the functioning of banks in the country. PCA guidelines are prefixed by RBI. PCA risk threshold are mainly defined in terms of Capital, Asset Quality, Profitability, and Leverage:

Exhibit : PCA Indicators
Capital	CRAR- Minimum regulatory prescription for Capital to Risk Assets Ratio + applicable Capital Conservation Buffer (CCB) Current minimum RBI prescription is 10.875% (9% minimum total capital plus 1.875% of CCB). And/Or Common Equity Tier 1 (CET 1 minimum) + applicable CCB. Current minimum RBI prescription is 7.375% (5.5% plus 1.875% of CCB)
Asset Quality	Net Non-performing advances (NNPA) ratio. This should be maintained at less than 6%.
Profitability	Return on assets (ROA) (ROA is the percentage of profit after tax to average total assets). Banks should not have negative ROA for two consecutive years.
Leverage	Tier 1 Leverage ratio. This should be maintained above 4%.

Any bank breaching/ not maintaining the risk threshold set under the guidelines is subject to imposing of PCA restrictions by RBI. Banks falling under PCA face restriction/control on credit expansions, and are required to reduce risk assets, loan concentrations apart from many other corrective actions to be taken as per RBI directives.

The spiralling level of growing NPAs (reached to about Rs.10.39 trillions in FY 18) in the country has led to eleven public sector banks namely Allahabad Bank, Bank of India, Bank of Maharashtra, Central Bank of India, Corporation Bank, Dena Bank, Indian Overseas Bank, IDBI Bank, Oriental Bank of Commerce, Uco Bank and United Bank of India, falling under PCA.

When eleven out of the 21 public sector banks face PCA with resultant credit restrictions/controls then it causes cascading negative effects on the industry and industrial growth which is already struggling in a recessionary environment. However, the issue does not end at the formal credit restrictions. PCA comes with its adverse side effects also.

The credit restriction/controls have not only stopped the new credit dispersion, it has affected also the existing credit baskets. The managements of these banks have become comparatively conservative and cautious in their approach in rolling over of even the existing credit facilities to the industries by increasing the pricing, margins, and stipulating various other terms and conditions which are difficult to afford when industries are still adjusting to the double whammy impact of demonetization and GST. LoU/LoC instruments helping in availing finance at cheaper cost in Buyer’s Credit route have been already discontinued by the regulator. The liquidity crisis caused by IL&FS fiasco has further worsened the situation.

Many of the corporate borrowers already suffering from lower demand, shrinking margins, extended operating cycles, stretched receivable periods, tight liquidity position have been told by PCA banks to find new lenders to shift the existing credit facilities or for meeting their additional credit requirements. However, the non PCA banks have been also treading cautiously in their lending approach towards such borrowers or avoiding exposure to credit starve sectors such as steel, infrastructure, construction, textile etc. In fact some of the non PCA banks lowered their bank line exposure to PCA banks and started directly/indirectly declining discounting of bills issued under the LCs of PCA banks. Such reactions within banking industry have disappointed MSME/mid corporate borrowers. 

As per Economic indicators, the growth in credit to industry was virtually nil in first nine months of FY 2018-19. The growth of 7.70% reflected in bank credits during the first nine months of FY 2018-19 is mainly driven by retail and service sectors and manufacturing sector is lagging behind on this front. As per Index of Industrial Production (IIP) numbers, as of Nov 2018, the growth in IIP was mere 5%. In this environment, the formal impact of PCA on credit control has caused multi fold impact with indirect hit of credit squeeze.

Many borrowers have been cancelled sanctioned limits/loans by PCA banks. This has affected the business plans of corporates specially the MSME/mid corporates. The funding starvation caused by PCA forced many entrepreneurs to scale down/shelve their project plans. The sudden credit squeeze caused by these banks have created enormous pressure on the liquidity of MSME/mid corporates.  Many corporate are still struggling to adjust to this new situation. If the situation persists for long, the entrepreneurs may throw the towel and there could be increase in NPAs.

While efforts are being made by policy makers to salvage the economy from recession and encourage entrepreneurs for increasing private capital expenditure by setting up Greenfield / Brownfield projects, the entrepreneurs are facing a situation where banks are following cautious approach in corporate lending and chasing retail business.

With the Government’s lobbying with regulator in the positive environment of improving recovery through IBC, improving performance of some of the PCA banks, recapitalization of some of the banks by Govt/other stakeholders, change in guard at the regulator etc., it is expected that RBI may bring some banks out of PCA. In fact recently, RBI has decided to release Bank of India, Bank of Maharashtra, and Oriental Bank of Commerce from PCA. The fresh capital infusion announced by GoI for Allahabad Bank and Corporation Bank is also expected to help these banks coming out of PCA. Restoration of LoU/LoC for availing Buyer’s Credit with proper safeguards would be a boost not only to the corporate sector but also to the businesses of the foreign branches of Indian banks. Presently, when banks are competing to garner deposits at higher costs, a low rate of interest regime seems to be a distant dream, but if it happens (considering the GoI’s/regulator’s efforts in this direction), it would be a blessing in disguise for the industries. These positive measures would help in improving the liquidity starving industries and avoid unwanted new NPAs. However, the pain caused by PCA coupled with impact of LoU/LoC ban, IL&FS debacle and other such events, leading to credit squeeze shall be an unforgettable excruciating experience for the entrepreneurs and financial market forever.

Disclaimer: The views expressed in the article above are personal views of the author and should not be thought to represent official views, ideas, or policies of any agency or institution.

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Entrepreneurship @ Club 40 MENTAL : Bankers Perspective

Well, the culture of start-ups and entrepreneurship is brewing in the country and financial sector (specially venture capital world) has gained unparalleled experience of supporting this class of business enthusiasts. There are plenty of successful stories about the people having passion for entrepreneurship, volcanic spirit to conquer the markets and benefiting the society with their innovative products and services.

Governments of India’s (GoIs) efforts in this direction to encourage and support entrepreneurship are also laudable. Government has launched many schemes like Stand Up India, Mudra Loans, and other MSME loans etc. By effectively monitoring the schemes and ensuring successful implementation, we must appreciate that GoI has walked the talk on this front. As per reports, Government has ensured disbursement of about Rs.2.20 lakh crore during FY 2017-18 in support to MSME by way of Mudra Loans, and 2018-19 Budget has increased this target to Rs.3 lakh crore. Budget 2018-19 has also made provision of Rs.3794 crore for MSMEs for providing credit support, capital and interest subsidy and innovations in this sector.  There are other initiatives also like Fund of Fund by SIDBI for (Corpus Rs.10,000 crore) contribution to various Alternative Investment Funds (AIFs) for facilitating funding needs for Start-ups through participation by VCs.

In a conductive policy environment, it is also a fact that the banking industry in the country is facing highest levels of NPAs (about Rs. 8 lakh crore) and there is defeating confidence in lenders in supporting existing businesses. The credit off-take is tepid despite all policy efforts are being made to encourage industrial lending. Banks in the country have been tending in funding well established business models based on traditional collateral/mortgaged based funding. Therefore, funding to fresh entrepreneurs coming out of campuses does not come easy to them. It is in light of this that the entrepreneurs starting their ventures in their 40s may have some advantage in having the bankers on their side.

This club 40 has many traits which a lender would be looking for in experimenting with start-ups lending. Mostly the people coming in this class have huge 15-18 years of experience (EXPERIENCED) of running factories/organizations, dealing with people, showing their leadership skills (LEADERSHIP), experimenting with products/services/technology (TESTED) etc. They have the advantage of knowing the deficiencies in the existing business models and the right vacuum to be filled up. They carry a good market reputation and relationships (NETWORKED) which support them in taking forward their new ventures. Their maturity level also supports them in taking calculated risks (MATURED). They have bitter taste of non performance and know how to cope up with tough situations. They have knowledge of their market and possess quality of being aggressive to capture the same (AGGRESSIVE). Many of the entrepreneurs in this group also do not face issue of initial seed capital support due to their available savings.

This class is expected to be able to convince not only the investors but also the lenders with their credentials in getting the right kind of capital for supporting their business ventures. The VCs in the market have already experimented with the earlier class of freshly young entrepreneurs coming out directly from their colleges. Now these VCs as well PEs are looking forward to balance their investment portfolio with seasoned experienced professionals aspiring to come out from their cabins.

With the corporate segment funding being in low confidence, banks are eying other segments where they can develop business. Affordable Housing and MSME are the key sectors which banks are targeting at this juncture. The confidence given by Mudra Loans, Start ups Loans etc. have created positive vibes where banks seems to be now looking beyond collaterals for these small/medium loans and may experiment with ventures giving sustained outcomes backed by these matured class of entrepreneurs. As compared to equity capital, the debt capital has its own advantage for entrepreneurs since it does not require them diluting stakes during the initial stage when it is valued low, and provides freedom of experimenting without any outside intervention. The 3Cs of Credit (Character, Capacity and Capital) seem to be favoring MENTAL (Matured, Experienced, Networked, Tested, Aggressive, Leaders) of Club 40 with not only banks but also NBFCs and other institutions coming forward with MSME/Start-ups oriented debt products specially targeted towards entrepreneurs. Just to cite, there were about 27 public sector banks, 18 private sector banks, 31 NBFCs, 31 regional rural banks, 13 state co-operative urban banks, 73 micro finance institutions as of March 2017 partnered for Mudra loans, and the list is expected to further grow. Hence, Club 40 @ MENTAL may look forward with lenders supporting their ventures without the need for compromising and diluting stakes. Budding entrepreneurs may follow some of the under given suggestions while looking for financing from banks:

- Many banks have specialized branches for SME/corporate lending. Some of the banks have even opened dedicated branches for Start-ups. Hence, find out the right branch for your funding requirement and approach the right officer.

- Find out if the bank has any specific format/details in which proposal needs to be submitted. It will save lot of time.

- Find out if there is any specific subsidy/grant or interest relaxation etc. provided under any central/state government scheme for funding of product/service/MSE in which your firm can be categorized. Try to get financing under these schemes which may save cost.

- Submit an executive summary of proposal having about three to four pages that should mainly provide basic details of the borrower, experience, cost and sources of financing, repayment sources, key financials, key strengths and present status.

- Submit a detailed proposal that should explain about the management aspects, market, technical aspects, projected financials along with assumptions and basis for the same. Support proposal along with copies of quotations received, any supporting report relied upon, registration certificates/licenses, validation/viability/appraisal reports, three years IT-returns, valuation of any collateral offered, client testimonials etc.  Additionally, supplying soft copies of these documents to the assessment officer may expedite processing.

- Club 40 must emphasize their past experience, successful track record, reputation and ability to drive up the proposed Start-up as future success story.

- There is growing interest in banks also in funding Start-ups in order to develop future business and branding opportunities with them. Hence, while discussing/submitting your proposal highlight advantages (in terms of future business, cross sell opportunities, payroll accounts, retail business opportunities and branding etc, if any) to the bank in associating with your Start-up at its nascent/present stage.   

- Do not rely on one bank/institution. Submit your proposal to at least 3-4 banks.

- Be in regular touch with the assessment officers and supply them any additional required information.    

Letter of Undertaking (LoU) / Letter of Comfort (LoC) Ban and Impact

The scam based on misuse of the system of Letter of Undertaking (LoU) issued by banks in India has created a setback for the lenders and regulators in the country. The incident has affected the lending confidence and raised questions on monitoring and compliance. It has recently resulted in ban of LoUs and Letter of Comfort (LoCs) instruments for trade credits for imports in India by the banking regulator. The regulator has kept the use of Letter of Credits (LCs) and Bank Guarantees open for trade credit imports (subject to compliance with the provisions). More clarity is expected to emerge from regulators in future on trade facilitation through LC/BG. Much is being talked about the ban since its announcement. While industry bodies have complained of liquidity crunch, possible defaults, profitability impact etc., its supporters have claimed that now the financial system would be more opaque and restriction will help in improved discipline.

In the above context let’s have a simple case analysis how and why LoU/LoC come into the process:

Company XYZ is in a business where it needs to import some raw materials (RM). It has a cash credit facility sanctioned from its bank at rate of interest say of 9% p.a. and also has sanctioned LoU line.

It issues a import order to the supplier and on the date of payment, has two options (subject to its operating cycle) : (1) Use Rupee based cash credit (CC) facility at 9% p.a., buy foreign exchange (FC) and make payment (2) Provide LoU from the bank to a foreign bank outside India (or foreign branches of Indian banks) and avail foreign currency (say USD) short term loan @ 3.5% p.a. (plus some marginal LoU commission), and use the loan (say 3 months tenor) for payment to supplier. By the end of 3 months, make finished goods from the RM sourced, supply it and realize revenues. Use revenues to make repayment of FC loan. Thus, XYZ Co. got saved from using the comparatively costly Rupee based cash credit facility for 3 months, resulting in huge saving of 5.50% interest cost (excluding the hedging cost if not naturally hedged). The saving in cost not only resulted in improving profit margins but also helped in remaining competitive in the global market where competitors have access to low cost funding. Additionally, the unused Cash credit also helped in readily available stand by line for managing liquidity. 

XYZ Co. has been continuously working under the above mentioned two options depending on its need and managing its business, cashflows and liquidity. Now, say XYZ had planned its payments to suppliers under the option two above while managing its liquidity. But on the date of making payment to supplier, its bank refuses to allow using LoU line (due to regulatory ban or uneasy market conditions). Its a catastrophe like situation for XYZ because its cash credit line might be already fully used (or planned for other different payments) and has no other freely available cash flow. This results in loss of market reputation, affects the whole business cycle, business goes for a toss and XYZ defaults to its lenders and creditors.

It would not be difficult to say that in the absence of LoUs, companies like XYZ can plan their business with the other available cash credit, short term/long term loans, ECB loans and bank guarantees etc. other products depending on guidelines. However, unplugging LoU suddenly has a heavy bearing on any MSME or Mid/Large corporate and they can be devastated. Hence, it is clear that it would have been better if six to nine months time was provided to corporates before banning LoUs so that they could adjust to the new situation and manage their cash flows. Not providing sufficient time may increase stressed accounts in banking industry which is already suffering from mounting NPAs.

As per Department of Economic Affairs (DEA), Ministry of Finance (MoF) data, the short term external debt of the country as on September 30, 2017 was about USD 93 billion of which USD 92 billion was related to trade credits. Of this, USD 60 billion has maturity between six months to one year while USD 32 billion has maturity within six months. With such huge size of trade credit debt, discontinuation of significant instruments like LoUs could create mayhem in the credit and forex market. With the unexpected ban on LoUs, corporate will have unplanned need of buying foreign exchange for either paying to suppliers or to foreign lenders (since not being allowed to roll over LoUs now). This is expected to create pressure on Rupee in near term because the planned payments at a distance of six to one year will now fall for payment immediately. Their hedging, forward booking etc. and all other planning may go to toss and it may also create additional cost burden. Already regulator has been pushing hard corporates in taking action for hedging their foreign currency risk. Corporates would be discouraged in the hedging expenditure in future when these planning fail.

Resorting to the other options in a severely affected banking industry fighting with NPAs and low confidence on credit side would not be easy. Further in this credit tight scenario, sanction of any fresh loans/facilities takes time, followed by other procedures like documentation, charge creation, pre disbursement compliances, collateral arrangements etc. LoUs/LoCs have been one of the key businesses of the off-shore banking units of the Indian banks in abroad. Ban on this business would also affect profitability of these centres.

Government has supported by many schemes improving competitiveness of Indian businesses in the globalized trade. Increase in the cost due to ban of LoUs/LoCs would result in demand for other subsidies and schemes from government by corporate India in order to survive and remain competitive. Any such new scheme will have bearing on tax payers money.

Technology development in banking sector is in advance stages and various new concepts like artificial intelligence and block chain are reported to be supportive in conducting a safe and secure trade finance business. It would have been better that when banks have learnt a painful lesson from the LoU fiasco, they could be encouraged in adopting these new technologies in order to facilitate safer and faster business. 

(Note: Views expressed are Personal)

Article on Crowd Based Income Generating Collateral Pools

Lending to EPC Sector in Troubled Waters

The gross Non Performing Assets (NPAs) of banks in India were Rs.3.23 lakh crore (USD 48 bn) as on March 31, 2015 as per RBI, and estimated at approx. Rs. 6 lakh crore (USD 88 bn) as on March 31, 2016. The NPAs are mainly in infrastructure sector, textile, iron & steel etc. As per various reports the growth rate of Indian economy is projected at 7% for FY 2016-17. However, the credit growth rate in the country has declined in infrastructure and manufacturing sector as lenders are struggling with growing NPAs. Infrastructure sector forms a major part of bank credit with share of 36 per cent (as on November 2015). Of which Road & Other infrastructure forms 30 per cent of the bank credit. The peaking levels of NPAs have cautioned banks in selective and conservative lending approach. Government of India is putting efforts for revival of Economic scenario by way of several reforms. In road infra sector, 10,000 Km of highway contracts worth Rs. 1 lakh crore (USD 15 bn) were awarded and 6000 Km were constructed in 2015-16. Government has targeted to award 25000 Km and construct 15000 Km for 2016-17. This would result in award of contracts worth Rs.2.50 lakh crore (USD 37 bn). The government has set target to increase the per day road construction from 20 Km to 40 Km. The newly introduced Hybrid Annuity Model (HAM) is reviving the interest of developers/contractors in the road projects.

The Ministry of Railways is working on several projects that includes modernization/ renovation of railway stations, tracks, faster trains etc. having expenditure of Rs.8.6 lakh crore (USD 127 bn). The Indian Railways has rolled out plans to redevelop 400 stations. The Ministry of Railways will be also taking up 21 port-rail connectivity projects, at an estimated cost of more than Rs.20,000 crore (USD 3 bn), under the port-connectivity enhancement objective of Sagarmala, the flagship programme of the Ministry of Shipping. In addition, another six projects are being considered by the Indian Port Rail Corporation Limited (IPRCL). The Aviation Ministry planned to improve and modernize the airport infrastructure in the country. To boost air connectivity, the government has planned to revive 160 airports and airstrips, each of would cost about Rs. 50-100 crore (USD 7 – 15 mn). Government has planned to develop 200 low cost airports for connecting tier II & III cities. Airport Authority of India (AAI) has planned to invest Rs.15,000 crore (USD 2.20 bn) over the next four years in the development and upgradation of airports. Government's vision of creating 100 smart cities will require an investment of over USD 150 billion over the next few years.

All the above upcoming projects provide enormous opportunities of growth for the EPC/Construction sector. Going with the scope of growth available, the companies in the sector would require fund based and non fund based facilities from banks for undertaking these projects. Having experienced the large scale of NPAs from the infrastructure/EPC sectors, it creates a challenge for banks to meet needs of EPC sector.  In light of this, it is important to visit some of the prudent practices which could help in constructive lending to the EPC sector while mitigating the risks of defaults.

Monitoring Project Progress

The time has gone when the lenders used to issue Bank Guarantees (BGs) and remain under the impression that being EPC project, the BGs will get returned on completion of the project. In many of the cases, it has been seen that the beneficiaries stipulate onerous clauses in the guarantee formats which prevent auto reduction of liability under the BG with the achievement of progress of project. Many a time justifications are provided that performance BG requirement is linked to complete product delivery and cannot be reduced with the intermediate milestone achievements. While accepting such logics, banks need to remember that they should be providing the performance BG related to contractor’s performance, his capability to complete a project with the required standards, based on the detailed analysis of his strengths, past track records, years of experience, credibility and reputation achieved in the field, but banks are not institutions to provide the product performance insurance in the disguise of performance BG.  Remember, there is huge difference in cost of insurance premiums and BG commissions. Inflexibility of project authority is another prime reason which is sighted for insertion of onerous clauses/deletion of mandatory clauses. Such stubborn practices are not good for the long term progress of the sector. With the changing time, it is imperative for lenders to regularly monitor the progress of the projects. Lenders need to have regular update on the progress of project and milestones achieved. Such reports can be submitted by borrowers along with monthly stock/receivable statements. Many such reports/details are generally ready with contractors as they also maintain project progress status for billing/accounting/taxation and various other purposes. Since delays may cause increase in project cost and if the same are not condone by the project authorities, it may thereat invocation of bank guarantees.

Depending on the size and exposure to the projects, consortium lenders may decide to appoint Lender’s Independent Engineer (LIE) for providing quarterly/half yearly update on the projects. When a small housing loan is processed, banks send independent valuer to the project site for report on the physical progress of the project. After sanction of home loan, before each disbursement also valuer revisits the project site and submits report on further progress made. Based on such reports, home loan disbursements are made. Taking this as basic concept of prudence, it is important that bankers as a community may adopt the practice of obtaining independent project progress reports.

Interactions with the Project Authorities

In my experience, I have seen that visiting the project sites from time to time gives a real understanding of the project, progress made and provides opportunity for interaction with the project authorities and project team of the borrower/contractor/sub-contractors. This exposes us to the ground level reality of the development, issues involved, satisfaction of the project authorities with the work being done by the contractor. Periodic visits help in seeing the real progress made at the project. It provides opportunity to have a one to one dialogue with project authority helping in understanding whether the project is moving as per the timelines or there is likelihood of extension/penalties which may affect the BGs issued, and liquidity of the contractor.

Milestone Based Bank Guarantees

It is seen that when borrowers submit single bank guarantee for the entire contract, it causes in incurring commission for the entire value and period. With the achievement of project milestones, the requirement of BG value also reduces, however pursuing the project authorities approving reduction in BG value is a herculean task. Therefore, borrowers need to negotiate with the project authorities at the inception only for allowing multiple BGs having different values and periods linked with project milestones (value and period). This supports in easy cancellation of BGs with the achievement of project milestones, unlocking the BG limits and saving of cost.  

Project Specific Limits

Banks sanction open ended fund based and non fund based working capital limits to EPC companies generally without limiting to any specific project. Learning from the past experiences, it would be prudent that while a portion of the overall limit may be carved out for general bidding purpose, banks need to strive for approving project specific limits for contracts awarded to the borrower. Carving out of project specific limit would automatically lead to the requirement of detailed assessment of the project as well periodic monitoring. Such practice would help in better understanding and control of the project performance, and risks/issues involved.     

Building up Margins

Implementation of projects in infrastructure/construction sector depends on many factors involving various clearances like right of way etc. The BGs issued also have to be extended by the contractors due to delays in getting these approvals. As many of the projects come in hinterlands, IBA approved transporters are also sometimes not available in these project areas for supplies/transportation of materials. Apart from this, as mentioned earlier, the inflexible nature of project authorities also leads to waiver of prudent mandatory clauses, or insertion of onerous clauses. Considering all these factors and importance of cash flows, it is important that like DSRA Reserves are monitored by lenders, the cash/FDR margins for LC/BGs also needs to put in the centre of monitoring. It has to be a financial Lever and depending on the project intricacies, insertion of onerous clauses of waiver of mandatory clauses, project progress, extensions allowed, banks need to increase/build up the margin for such exposures.

Escrow Arrangements

In the past it has been seen that some borrowers diverted the advance payments received from one project to other projects in their difficult times. This results in affecting the progress of the various projects, dissatisfaction of the project authorities and invocation of BGs. In order to avoid such circumstances, it would be prudent to monitor the cash flows of the projects through Escrow A/c arrangements. This is specially required when there is a sub-contract arrangement. The standard formats of BGs stipulate effectiveness of BG only after receipt of advance payments in to account of the borrower with the BG issuing bank. Such compulsory clauses should not be relaxed.

Concurrent Auditor

RBI has made it compulsory forming consortium arrangements for borrowers availing more than Rs.100 crore (USD 15 mn) (SMA2 A/cs) of borrowings from banks. Many mid/large EPC companies are banking under consortium arrangement. The EPC companies being involved with many projects, it is essential for the consortium to have real understanding on the project cash flows of the borrower. Control on the cash flows is one of the most critical aspects in lending. I had written earlier about this in my article (Time to set New Normal : Adopting Cash Flow Based Monitoring). In all the restructured cases banks appoint Concurrent Auditor for monthly/quarterly reports on the cash flows, receivable position, intergroup/related party transaction etc. Considering the multiple project cash flows, it would be prudent that consortium adopts practice of appointing Concurrent Auditors in lending to EPC contractors. Such practice would help in understanding the project cash flows.

Needless to say, the Early Warning System (EWS) put in practice by banks in India is component of the overall monitoring framework and has to be followed for timely mitigation actions.

With the efforts of Government of India many contract opportunities are opening for the EPC/Construction sector and providing room for business growth to contractors as well as lenders. Prudent controlling and monitoring practices would not only support in constructive lending but also protect the interest of all the stakeholders in long term.