IL & FS CR I SI S
Why in News?
Recently an infrastructure financing company, Infrastructure Leasing & Financial Services (IL&FS), an NBFC, defaulted on their loan repayment.
Background
IL&FS Group is a vast conglomerate with a complex corporate structure that funds infrastructure projects across the world’s fastest-growing major economy like Chenani- Nashri road tunnel, India’s longest and has raised billions of dollars from the country’s corporate debt market.
IL&FS is a Systematically Important Non- Deposit Core Investment Company (CIC-ND- SI) i.e. any crisis at IL&FS would not only impact equity and debt markets but could also stall several infrastructure projects of national importance.
Many major corporates, banks, mutual funds, insurance companies, etc. such as LIC, HDFC and SBI have stakes in the IL&FS group.
Possible Reason for Default
Critical lapse in Corporate Governance Norms: as Risk Management Committee, constituted met only once between 2015 and
2018.
Shareholder Negligence: Well-known institutions such as LIC, HDFC, etc. which were major shareholder in ILF&S are guilty of negligence. For example, HDFC had not nominated a director to the board of IL&FS since last year.
Asset-liability mismatch and weak corporate bond market: IL&FS owns long-term infrastructure financed with short-term funding because long-term (tenure of more than 10 years) debt is not available in India. This resulted in defaulting in one of the short- term repayment obligation due to various reasons like:
o Slow pace of new infrastructure projects
in India, and some of IL&FS’s own
construction projects, including roads and ports, have faced cost overruns amid delays in land acquisition and approvals. Disputes over contracts have locked about Rs 9,000 crore of payments due from the government.
As per RBI, CIC-ND-SI is a Non-Banking Financial Company
(NBFC)
With asset size of Rs 100 crore and above.
It holds not less than 90% of its net assets in the form of investment in equity shares, preference shares, bonds, debentures, debt or loans in group companies.
Its investments in the equity shares (including instruments compulsorily convertible into equity shares within a period not exceeding 10 years from the date of issue) in group companies constitutes not less than 60% of its net assets.
It does not trade in its investments in shares, bonds, debentures, debt or loans in group companies except through block sale for the purpose of dilution or disinvestment.
It accepts public funds
Shadow Banking System
Shadow banking is that part of the financial system where credit intermediation involving entities and activities remains outside the regular banking system. The term was coined by economist Paul McCulley in 2007.
Working structure: They have a higher cost of funding. But the lack of regulatory oversight allows them to take on more risks than banks. So, they can cut corners and earn higher returns. They can also go bust more spectacularly.
Significance: They provides a valuable alternative to bank funding and helps support real economic activity. It is also a welcome source of diversification of credit supply from the banking system, and provides healthy competition for banks.
Lack of Effective Regulation:
o RBI which oversees NBFCs like IL&FS and the union finance ministry which oversees major shareholders like LIC, SBI, etc. are at fault here as the crisis was allowed to develop over a period of time.
Impact of Crisis
India’s Lehman Brothers moment: IL&FS debt papers enjoyed highest safety status by Credit rating Agency, for a long time on account of factors such as satisfactory liquidity conditions and the backing of major public sector units. However, current crisis reflects Failure of Credit Rating Agencies.
o The lack of confidence in the credit ratings is in danger of undermining India’s financial stability, leading
to a drying up of credit lines for shadow lenders and wider concerns about the impact on the economy.
Lack of Capital Expenditure: It’s impact may spill over into the wider infrastructure industry, pushing up
funding costs and pulling government investment plans for achieving New India by 2022.
Impact on Stock Market: It might witness significant repercussions, including widespread redemption pressures, sell-off in the debt market, liquidity crunch and possible cancellation of licences of as many as 1,500 smaller non-banking financial companies (NBFCs) due to lack of adequate capital.
Liquidity crisis: There are concerns over short-term liquidity in the market for commercial papers raised by
NBFCs.
Impact on Shadow Banking: According to RBI, India has about 11,000 shadow financing companies, out of which 248 are systemically important non-deposit taking institutions, who will face greater regulatory scrutiny and short term liquidity crisis, which could impact the sustainability of many NBFC’s.
Other cascading effects of IL&FS’s defaults: Rising borrowing costs, exacerbated by the turmoil in markets in recent days, will lead to a credit crunch in the sector.
Steps Taken by Government
Taking Managing Control: Government superseded the IL&FS board under section
241(2) of the Companies Act, 2013, which enables supersession of a company’s board to prevent it from further mismanagement in order to protect public interest. Its Implications are
o Increasing Confidence of Lenders by giving them assurance that their
outstanding loans to IL&FS will be repaid. o Improving Financial Market Stability: It effectively stops the spread of systemic instability in an inter-connected financial system, especially as panic had started spreading across the financial, money
and capital markets.
o It helps in restoring the confidence of the financial market and Ease of doing Business in India.
Government has also ordered Serious Fraud Investigation Office (SFIO) to investigate into the affairs of crisis-hit IL & FS and its subsidiaries amid concerns over financial irregularities.
Way Forward
Short Term Measures like finalization of a restructuring plan, identification and valuation of assets, sale of the assets and repayment of outstanding loans.
o Government must arrange adequate liquidity for IL&FS to obviate future defaults and ensure smooth implementation of infrastructure projects.
Strenghtening Corporate Governance norms by implementing Kotak panel recommendation and incentivize boards to play a more effective role in supervising company executives.
Shareholders awareness: Shareholders must be more actively involved in keeping tab on the key policy decisions of the companies.
Effective checks and balance system at the firm level to check any discrepencies at initial level.
Leveraging National Financial Reporting Authority for enforcement of auditing standards and ensuring the quality of audits to strengthen quality of audits and enhance investor & public confidence in financial disclosures of companies.
Creating an independent regulator for credit rating agencies, to have rating actions in a proactive manner rather than a reactive manner.
o Rating agencies also need better market intelligence and surveillance rather than depending upon historical data and some structure based on past estimates.
Deepening the debt markets:
o The Centre and the RBI should look at ways to provide access to infrastructure players like ILF&S to borrow long-term funds.
o The successful resolution of issues of banks’ non-performing assets (NPAs) through the Insolvency and
Bankruptcy Code (IBC) can increase sources of long-term debt.
o The Indian corporate bond market is currently skewed towards high-rated debt instruments (AA and AAA)
as most regulators in India have set a minimum of ‘AA’ rating for bonds to be eligible for investment. In
line with the budget announcement, the government should work with various regulators to allow increased investment in relatively lower-rated bonds.
Timely Project clearances: Ensuring timely clearances, especially to infrastructural projects is a must to minimise cost inflation of these projects. Expanding the “Plug and Play” approach to other sectors can be a possible solution.
Improved Ratings Accuracy:
o Securities and Exchange Board of India (SEBI) should examine the process for issuing ratings for corporate bonds and figure out why the rating agencies did not spot early signs of the crisis.
o There should not be undue importance on who is the promoter backing the company while providing ratings. Instead loan amount, asset quality, profitability, etc. should be basis for assigning rating to the company.
Why in News?
Recently an infrastructure financing company, Infrastructure Leasing & Financial Services (IL&FS), an NBFC, defaulted on their loan repayment.
Background
IL&FS Group is a vast conglomerate with a complex corporate structure that funds infrastructure projects across the world’s fastest-growing major economy like Chenani- Nashri road tunnel, India’s longest and has raised billions of dollars from the country’s corporate debt market.
IL&FS is a Systematically Important Non- Deposit Core Investment Company (CIC-ND- SI) i.e. any crisis at IL&FS would not only impact equity and debt markets but could also stall several infrastructure projects of national importance.
Many major corporates, banks, mutual funds, insurance companies, etc. such as LIC, HDFC and SBI have stakes in the IL&FS group.
Possible Reason for Default
Critical lapse in Corporate Governance Norms: as Risk Management Committee, constituted met only once between 2015 and
2018.
Shareholder Negligence: Well-known institutions such as LIC, HDFC, etc. which were major shareholder in ILF&S are guilty of negligence. For example, HDFC had not nominated a director to the board of IL&FS since last year.
Asset-liability mismatch and weak corporate bond market: IL&FS owns long-term infrastructure financed with short-term funding because long-term (tenure of more than 10 years) debt is not available in India. This resulted in defaulting in one of the short- term repayment obligation due to various reasons like:
o Slow pace of new infrastructure projects
in India, and some of IL&FS’s own
construction projects, including roads and ports, have faced cost overruns amid delays in land acquisition and approvals. Disputes over contracts have locked about Rs 9,000 crore of payments due from the government.
As per RBI, CIC-ND-SI is a Non-Banking Financial Company
(NBFC)
With asset size of Rs 100 crore and above.
It holds not less than 90% of its net assets in the form of investment in equity shares, preference shares, bonds, debentures, debt or loans in group companies.
Its investments in the equity shares (including instruments compulsorily convertible into equity shares within a period not exceeding 10 years from the date of issue) in group companies constitutes not less than 60% of its net assets.
It does not trade in its investments in shares, bonds, debentures, debt or loans in group companies except through block sale for the purpose of dilution or disinvestment.
It accepts public funds
Shadow Banking System
Shadow banking is that part of the financial system where credit intermediation involving entities and activities remains outside the regular banking system. The term was coined by economist Paul McCulley in 2007.
Working structure: They have a higher cost of funding. But the lack of regulatory oversight allows them to take on more risks than banks. So, they can cut corners and earn higher returns. They can also go bust more spectacularly.
Significance: They provides a valuable alternative to bank funding and helps support real economic activity. It is also a welcome source of diversification of credit supply from the banking system, and provides healthy competition for banks.
Lack of Effective Regulation:
o RBI which oversees NBFCs like IL&FS and the union finance ministry which oversees major shareholders like LIC, SBI, etc. are at fault here as the crisis was allowed to develop over a period of time.
Impact of Crisis
India’s Lehman Brothers moment: IL&FS debt papers enjoyed highest safety status by Credit rating Agency, for a long time on account of factors such as satisfactory liquidity conditions and the backing of major public sector units. However, current crisis reflects Failure of Credit Rating Agencies.
o The lack of confidence in the credit ratings is in danger of undermining India’s financial stability, leading
to a drying up of credit lines for shadow lenders and wider concerns about the impact on the economy.
Lack of Capital Expenditure: It’s impact may spill over into the wider infrastructure industry, pushing up
funding costs and pulling government investment plans for achieving New India by 2022.
Impact on Stock Market: It might witness significant repercussions, including widespread redemption pressures, sell-off in the debt market, liquidity crunch and possible cancellation of licences of as many as 1,500 smaller non-banking financial companies (NBFCs) due to lack of adequate capital.
Liquidity crisis: There are concerns over short-term liquidity in the market for commercial papers raised by
NBFCs.
Impact on Shadow Banking: According to RBI, India has about 11,000 shadow financing companies, out of which 248 are systemically important non-deposit taking institutions, who will face greater regulatory scrutiny and short term liquidity crisis, which could impact the sustainability of many NBFC’s.
Other cascading effects of IL&FS’s defaults: Rising borrowing costs, exacerbated by the turmoil in markets in recent days, will lead to a credit crunch in the sector.
Steps Taken by Government
Taking Managing Control: Government superseded the IL&FS board under section
241(2) of the Companies Act, 2013, which enables supersession of a company’s board to prevent it from further mismanagement in order to protect public interest. Its Implications are
o Increasing Confidence of Lenders by giving them assurance that their
outstanding loans to IL&FS will be repaid. o Improving Financial Market Stability: It effectively stops the spread of systemic instability in an inter-connected financial system, especially as panic had started spreading across the financial, money
and capital markets.
o It helps in restoring the confidence of the financial market and Ease of doing Business in India.
Government has also ordered Serious Fraud Investigation Office (SFIO) to investigate into the affairs of crisis-hit IL & FS and its subsidiaries amid concerns over financial irregularities.
Way Forward
Short Term Measures like finalization of a restructuring plan, identification and valuation of assets, sale of the assets and repayment of outstanding loans.
o Government must arrange adequate liquidity for IL&FS to obviate future defaults and ensure smooth implementation of infrastructure projects.
Strenghtening Corporate Governance norms by implementing Kotak panel recommendation and incentivize boards to play a more effective role in supervising company executives.
Shareholders awareness: Shareholders must be more actively involved in keeping tab on the key policy decisions of the companies.
Effective checks and balance system at the firm level to check any discrepencies at initial level.
Leveraging National Financial Reporting Authority for enforcement of auditing standards and ensuring the quality of audits to strengthen quality of audits and enhance investor & public confidence in financial disclosures of companies.
Creating an independent regulator for credit rating agencies, to have rating actions in a proactive manner rather than a reactive manner.
o Rating agencies also need better market intelligence and surveillance rather than depending upon historical data and some structure based on past estimates.
Deepening the debt markets:
o The Centre and the RBI should look at ways to provide access to infrastructure players like ILF&S to borrow long-term funds.
o The successful resolution of issues of banks’ non-performing assets (NPAs) through the Insolvency and
Bankruptcy Code (IBC) can increase sources of long-term debt.
o The Indian corporate bond market is currently skewed towards high-rated debt instruments (AA and AAA)
as most regulators in India have set a minimum of ‘AA’ rating for bonds to be eligible for investment. In
line with the budget announcement, the government should work with various regulators to allow increased investment in relatively lower-rated bonds.
Timely Project clearances: Ensuring timely clearances, especially to infrastructural projects is a must to minimise cost inflation of these projects. Expanding the “Plug and Play” approach to other sectors can be a possible solution.
Improved Ratings Accuracy:
o Securities and Exchange Board of India (SEBI) should examine the process for issuing ratings for corporate bonds and figure out why the rating agencies did not spot early signs of the crisis.
o There should not be undue importance on who is the promoter backing the company while providing ratings. Instead loan amount, asset quality, profitability, etc. should be basis for assigning rating to the company.
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