IL and FS Crisis

Reasons for failure

• Surge in interest rates – of short term borrowings
• Too many subsidiaries– It has more than 250 subsidiaries, this makes the monitoring audit of the company difficult for any auditing firm or regulator.
• Lack of transparency on financial position– sparing lenders, even the credit rating agency which gave AAA rating to IL&FS didn’t have a clue about company’s financial position. This allows condition to get aggravated until it finally explodes as in Lehman brother’s case.
• Self–Lending : Too many loans to own subsidiaries which ultimately defaulted.
• Crony capitalism & kleptocracy – there have been known instances where things were deliberately hidden & projects were funded to please the ruling parties.
• Lack of distinctions b/w public & private projects – public money being used for private ones.

Issues in IL & FS crisis:

• Investors at Risk :  investors, which include banks(HDFC, SBI), insurance companies(LIC) and mutual funds. Even the value of unit-linked insurance plans, endowment plans, the National Pension Scheme, etc. will be hit.
• Public Money diversion : bailout is unavailable for other welfare-enhancing expenditures.
• Private lending is adversely affected.
• Poor corporate governance and lack of adequate regulation for monitoring systemically important firms as IL&FS.
• IL&FS has an extraordinarily complex corporate structure, with well over 100 subsidiaries. Problems can be hidden until they explode.
• Transparency and disclosure will also help markets work better. IL&FS was tapping bond markets while hiding its problems, so clearly lenders did not have an accurate picture of the company’s financial position nor did the rating agencies.
• Public ownership and influence can distort incentives and decision making. This has been a common problem in public sector banks, and was true for IL&FS.
• Non-banking financial companies (NBFC) Impacted :  stocks will be under pressure due to higher valuations. With banks cutting fresh lines of credit, there will be acute liquidity issues, hitting the NBFCs.
• Most of the IL&FS group’s assets include financial claims on infrastructure projects such as roads, tunnels, water treatment plants, and power stations, etc. which cannot be liquidated to escape the mess.
• A downgrade in the credit rating sends the bond’s price down, which affects debt funds.
• Indirect effects: For instance, several projects, including the Bengaluru Metro construction plans, are likely to be delayed, which will affect individuals, too, besides the firms involved.

Steps needed for course correction:

• Disclosure and transparency : Complexity of corporate structure and of asset portfolios can be counteracted by requiring more disclosure.
• Better regulation of corporate structures and stronger corporate governance.
• A clearer separation of public and private is needed, rather than the muddy links and ownership structures that now exist.

Need for unified regulator of NBFC:

• Series of defaults. ( IL&FS )
• NBFCs risks impacting banking system. ( back of bank funding is easy for corporates )
• No liquidity requirements for NBFCs ( SLR, CRR etc )
• International Experience : China – tightened its regulation related to P2P firms from 2016.
• Interconnected economy. Therefore unified regulations are important.
• Enable to identify systemic risks in advance.
• Recommended by FSLRC committee headed by B.N.Srikrishna.

Recommendations of the Working Group on Issues and Concerns in the NBFC Sector chaired by Usha Thorat in 2011.

• Introduction of a liquidity coverage ratio for NBFCs.
• Ensure that NBFCs have cash balances and holdings of government securities which may fully cover gaps between cumulative outflows and cumulative inflows for the first 30 days.
• The regulatory oversight on NBFC hitherto can be summarized as ‘much lighter on the assets, and absent on the liabilities’. This must change. Liabilities side regulations must be imposed, at least for the systemically important NBFCs.

If the institutional framework can be strengthened, greater entry and competition can generate the financing necessary for India’s infrastructure needs.