What is the market instrument at core of IL&FS woes?

What is the market instrument at core of IL&FS woes?

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1. Non-Banking Financial Companies (NBFCs) are facing capital crunch in the wake of IL&FS defaulting on its commercial papers.

Important Facts:

2. What is Commercial Paper?

Commercial Paper is an unsecured money market instrument issued in the form of promissory note.

CPs are short-term instruments and the maturity period varies from seven days to up to one year.

3. Purpose of CPs

The instrument was introduced in 1990 to enable highly rated corporate borrowers to diversify their sources of short-term borrowings, and also to provide an additional instrument to investors.

4. Who can issue CP?

CPs can be issued by corporates, primary dealers, and financial institutions.

Eligible participants should have a minimum credit rating of A-2 at the time of the issuance of the CP. Banking companies, mutual funds, other corporate bodies, NRIs, individuals and foreign institutional investors (FIIs) can subscribe to CPs; they are also traded in the secondary market.

About IL&FS crisis

5. IL&FS, a giant government-owned conglomerate that has executed, or is in the process of executing, some of the largest infrastructure projects in the country, is started to default on its commercial papers.
6. Credit rating agencies has downgraded IL&FS and its subsidiary ratings from high investment grade (AA plus and A1 plus) to junk status, indicating actual or imminent default.
7. This has led to panic in the debt market, and a drying up of liquidity in the system — and NBFCs and housing finance companies (HFCs) started to find it tough to carry out their normal businesses.

Effects of the default by IL&FS

8. Default by a big corporation like IL&FS is likely to keep away potential investors in debt instruments of Housing Finance companies (HFCs) and Non-Banking Finance Companies (NBFCs).
9. Sharp losses in NBFC stocks have triggered a vicious cycle — losses in leveraged positions are leading to selling in other stocks to cover those losses, which is in turn fuelling further losses in the market.

What IL&FS do?

10. IL&Fs raises funds for long-term projects.
11. While IL&FS needed funds for 10-15 years for execution of long-gestation projects, it usually raised funds for 8-10 years, and then got the project refinanced.
12. However, some three years back, when banks stopped refinancing and funding infrastructure projects, IL&FS was caught in a situation where it needed funds on an immediate basis in order to complete projects that were in various stages of execution.
13. It was then that IL&FS started looking at other sources of finance, including Commercial Papers (CP) and debenture issuances.

How IL&FS caught in a situation of asset-liability mismatch?

14. This led to IL&FS being caught in a situation of a big asset-liability mismatch, as it was using short-term funding instruments to finance long-term infrastructure projects.
15. With a huge requirement of funds but no availability, IL&FS reached a situation in which it could no longer honour its obligations, and started defaulting on commercial papers.