The Reserve Bank of India (RBI)’s instructions are anticipated to have a larger impact on public sector banks because the latter possess higher investments in infrastructure loans.

Over the last six months, there has been a massive 45% increase in the Nifty PSU Bank index. However, on May 6, RBI released a draft due to which the share of PSU banks dropped significantly. The draft suggests stricter norms for lending and monitoring under-construction infrastructure projects.

On May 3, RBI proposed that lenders should make higher provisions for all under-construction infrastructure projects and keep close watch on potential stress areas. Post this proposal, at around 11:45 am, Nifty PSU Bank index tanked 3.2%, with Punjab National Bank, Canara Bank, Bank of Baroda and Union Bank being the top drags – all down more than four percent each.

REC and Power Finance slipped up to 12 percent as these NBFCs have high exposure towards financing power projects which is an important part of infrastructure development.

This move will hurt public-sector lenders more as they have a larger portion of their loan book towards infrastructure loans. The regulator’s logic behind these suggestions lies in its past experience where it had seen large defaults happening on such loans which had brought banking system to its knees while India is experiencing huge number of infrastructure and manufacturing projects currently driven by government stimulations to revive economy therefore this time around it wants to ensure that similar crisis are avoided through stronger regulations.

What does RBI propose?

According to RBI during construction phase lenders will have to allocate five percent of loan amount as provisions and bring it down to 2.5 percent once project becomes operational. It gets further reduced one percent when project starts generating enough cash flows for meeting obligations. Phased implementation would require lenders making two percent provision in FY25 followed by 3.5 percent in FY26 and five percent by FY27.

Currently banks keep 0.4% provision on non-overdue/non-stressed project loans while also having requirement of accurately forecasting start date of commercial operations for a project along with provision adjustments in case of delays. Any delay of more than three years in commencing infrastructure project will lead to reclassification of loan from standard to stressed.

What will be its impact?

This would have different impacts depending upon how these guidelines are implemented, say analysts. According to Kotak Institutional Equities (KIE), caution has been instilled by memories of past corporate cycles though infrastructure loans form just about 8% of total loans vs over 15% in FY15. That apart, they are now more operational than under-construction projects with stronger balance sheets among promoters.

JM Financial predicts that the proposed guidelines may decrease returns for lenders in project finance and dampen their appetite for such exposures. It is a prudent risk management measure but could potentially hurt infrastructure sector growth because it is capital-intensive.

Public sector banks will face larger pressure than private peers due to higher exposure towards infra loans, says KIE which notes that former have lower exposure towards commercial real estate but higher share in infrastructure loans.

JM Financial estimates if implemented these guidelines can increase incremental credit costs for PSU banks by 12-21 bps.