IL&FS crisis

Context:

In response to the debt default by Infrastructure Leasing and Financial Services (IL&FS), the government has appointed a 6-member board to manage the IL&FS.

What is IL&FS?

• IL&FS Ltd, or Infrastructure Leasing & Finance Services, is a core investment company and serves as the holding company of the IL&FS Group.
• IL&FS was founded in 1987 with equity from Central Bank of India, Unit Trust of India and Housing Development Finance Co to fund infrastructure projects
• IL&FS’s major shareholders include: Life Insurance Corp of India holding 25.3% stake, State Bank of India with 6.42%, Japan’s Orix Corp holding 23% and the Abu Dhabi Investment Authority with 12%
• IL&FS is termed as a “shadow bank.” The term is used to refer to the non-bank financial intermediaries that provide services similar to traditional commercial banks.

Additional Information:

Non-bank financial Companies (NBFC): A NBFC is a company incorporated under the Companies Act, 1956 which is engaged in the business of Loans and Advances, Acquisition of stocks, equities, debt etc. issued by the government or any local authority. The main objective of this type of a company is to accept deposits under any scheme or manner.

Key differences between NBFCs and Banks:

Sources of Funds of NBFCs:

Long term: Term Loans are taken from banks in a single quantum, after deciding on the amount of funds to be deployed in the normal course of operations of the NBFC

Short term: Short term loans offered by an NBFC can be issued by raising funds through Commercial Paper (CPs). CPs are short term unsecured promissory notes issued by companies, with a tenure of 3 months to 12 months.

Others:

Debentures: debentures are typically issued to raise short-term capital for upcoming expenses or to pay for expansions. It is a type of debt instrument that is not secured by physical assets or collateral. Debentures are backed only by the general creditworthiness and reputation of the issuer.

Inter-Corporate Deposits (ICD): It is an unsecured borrowing by corporates and financial institutions from other corporate entities registered under the Companies Act 1956. The corporate having surplus funds would lend to another corporate in need of funds.

What is IL&FS crisis?

• IL&FS has run out of money and, therefore, has been unable to service its repayment obligations. According to the latest available data, the company has a total consolidated debt of Rs. 90,000 crores.
• The crisis began in august 2018, when ILFS defaulted on the payment of Rs.1000 Cr that was issued by SIDBI
• This was followed by a series of defaults on commercial papers, debentures, term loans and Inter-Corporate Deposits.

• The series of defaults led to a ratings downgrade. The credit rating of debt instruments issued by IL&FS was rated at AAA (highest credit rating) till the end of August 2018. Credit-rating agency ICRA downgraded the company’s creditworthiness to ‘D’ (default grade). Further, Credit rating agency CARE also downgraded several subsidiaries of IL&FS.
• A downgrade in the credit rating led to lowering of price of bond’s which affected debt funds.

Factors contributing to default:

1. Assets-Liability mismatch: The major reason for the crisis negative Asset liability mismatch as the outflow of liabilities became more than the inflow of assets.

• IL&FS invested in projects with a gestation period of 10 to 15 years by borrowing for a period of 8 to 10 years and then would get the project refinanced. But in the recent years the banks stopped refinancing (due to RBI guidelines) and the company was forced to borrow from the market by issuing CPs and debentures.
• Investing in long term assets but borrowing money on short duration debt instruments led to a huge asset liability mismatch.

2. Lack of access to short-term loans: Unlike Banks, NBFCs (like IL&FS) do not have access to RBI repo window.
3. Unviable Projects: Investment in unviable projects has been a major issue for ILFS and nearly 60000 crore debt of IL&FS is at project level including road power and water projects. The factors which slowed down infrastructure projects and made them unviable are:

• Complications in land acquisition
• Delay in environmental clearances and consequent delay in completion of projects
• Cost escalation also led to many incomplete projects
• Lack of timely action aggravated the problems

4. Structural defaults: The business structure of ILFS has a fundamental flaw which exposes it to both the financial and project risks in the infrastructure sector.

• Special Purpose Vehicle Model: As an investment company, IL&FS has no business of its own. It invests in subsidiaries, chiefly in infrastructure, financial services and education, which in turn invest in subsidiaries and associates executing projects. Again, the financial services entity invests in infrastructure and real estate, including in companies of the holding company.
• Generally, money is expected to flow back from the subsidiaries as dividends, interest payments on loans from the parent and even sale of these subsidiaries or associate companies. However, during crisis these payments get backed up, the whole organization is adversely affected.

5. Issues with management: The RBI had expressed concerns about the operations of IL&FS Financial Services (IFIN) in 2015. RBI’s inspection report pointed out “that the net-owned funds of the finance company had been wiped out and that it was over-leveraged.” Further, the report stated that the management had declined to take corrective measures

Issues/ Concerns:

1. Doubts over infrastructure projects: The government fears that IL&FS’s inability to finance and support the projects could damage the infrastructure sector.
2. PPP Model: The IL&FS crisis has raised concerns over India’s public-private partnership (PPP) programme to finance infrastructure projects. India’s PPP model in infrastructure has been crippled by delays, the poor health of sponsors, stressed assets and the reluctance of bank to provide funding has derailed many plans
3. Credibility of Rating Agencies: The credit rating industry has come under scrutiny after the firms that assessed IL&FS failed to see the financial troubles of IL&FS. This is because of undue weightage given to IL&FS’s parentage –The strength of the investors in the parent company and IL&FS was considered equal to a sovereign/public sector firm). This overrode the research and evaluation of underlying business and its ability to sustain and survive and failed to predict the crisis.
4. Accountability: Despite RBI raising concerns over the financial health of IL&FS, the company’s management failed to take corrective measures thus raising concerns over transparency, accountability and corporate governance of such companies.
5. Regulation: Unlike traditional banks, NBFCs are not strictly regulated. The IL&FS crisis has raised concerns over the regulation of such entities.

Impact of IL&FS crisis:

1. On debt market: A downgrade in credit rating lowers the bond’s price- this reflects in market price in traded bonds or rating agencies revalue the bonds. The extent of the fall depends on the nature of the downgrade. In IL&FS case, because the downgrade was steep –  from a top rating into below investment grade, the hit on prices was pronounced.
2. On other NBFCs:

• After the IL&FS crisis stocks of Housing Finance Companies (HFCs) and other non-banking financial institutions (NBFCs) fell down.
• According to rating agency Moody, NBFCs will be significantly impacted if the liquidity distress triggered by IL&FS crisis continues. Also, investors will hesitate in investing in NBFCs
• The IL&FS default could lead to Liquidity tightness thus consequently raising the financing costs for NBFCs.

3. On NPAs of Bank: Out of the total debt of IL&FS, Rs. 57000 crores have been taken from the banks. This can further aggravate the NPA burden on banks.
4. On Economy: According to Moodys, any effects on the NBFCs will spill over to the broader economy mainly through the credit channel because NBFCs are a ‘material provider of credit for the economy’.  Slowdown in credit growth provided by NBFCs will hamper overall consumption and economic growth

Options available to address crisis:

1. Offer right issues: This would enable IL&FS to generate extra funds to recapitalise. But as per media report a 4500cr right issue is highly under subscribed.

2. Sell assets to repay debt: IL&FS has approached National Company Law Tribunal for asset sale resolution and get liquidity to repay debtors. SBI has already proposed to buy good quality assets worth Rs 45,000 crore from NBFCs.
3. Address liquidity issues till the asset sale restarts: IL&FS could manage extra fund from financial institutions like LIC and SBI to pay its immediate liabilities.
4. Bailout by government: There is report of bailout of IL&FS by government. Although bailout plan may restore liquidity and avert another major bank collapse but it is highly expensive and set a bad precedent.

Steps taken:

1. New Board formed:

Post IL&FS crisis, the government filed a petition at NCLT under section 241 and 242 of Companies Act. The NCLT had allowed government to take over the board of the IL&FS fearing a contagion effect. Following this, the government appointed a new 6-member board to manage the IL&FS, which has been headed by Mr Uday Kotak.

2. Steps to increase liquidity and tackle credit crunch:

The RBI took the following steps-

• Conducted OMO (Open Market Operations)
• Relaxed liquidity norms to ease the strain in the financial markets and allowed more bank lending to NBFCs.  The provision will allow banks to free up Rs 50,000-60,000 crore of liquidity which banks can lend to NBFCs till December 31, 2018

Way ahead:

1. Centre should look at long-term solutions for pending clearances and payments by central agencies for infrastructure projects.
2. Adequate investigation into the affairs of the company is essential to ensure that the crisis does not lead to even bigger financial contagion and hamper the economy.
3. NBFCs should not have an aggressive asset liability management profile, instead evolve a culture of moderate growth and profitability. Further, NBFCs should adopt more transparency in terms of disclosure on the liability side to avoid any mismatch.
4. NBFCs should not rely on short term sources for funding long term projects.
5. Credit rating agencies should assess the standard of the corporate governance, the management team and the inherent business model of a company.
6. The IL&FS crisis has highlighted the loopholes in regulation of NBFCs and thus there is an urgent need to strengthen the regulatory framework of NBFCs