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What is the market instrument at core of IL&FS woes?
News
- Non-Banking Financial Companies (NBFCs) are facing capital crunch in the wake of IL&FS defaulting on its commercial papers.
Important Facts:
- 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.
- 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.
- 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
- 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.
- 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.
- 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
- 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).
- 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?
- IL&Fs raises funds for long-term projects.
- 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.
- 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.
- 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?
- 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.
- 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.
