Infrastructure Lending and Financial Services Limited (IL&FS) is one of the largest shadow-banking, infrastructure development and financial companies in India with more than 250 subsidiaries (including IL&FS Investment Managers, IL&FS Financial Services, IL&FS Transportation Networks India Limited) and its projects including some of the largest infrastructure projects like the Chennai-Nashri Tunnel in Kashmir, the longest tunnel in India. IL&FS was established in 1987 as an ‘RBI registered core Investment Company’ and it was started by three public financial institutions, namely, Central Bank of India, Housing Development Finance Cooperation (HFDC) and Union Trust of India (UTI) with the intent of providing finance and loans for major infrastructure development projects. With the burgeoning of IL&FS, there was need for better financing and it opened up to corporate giants like the Life Insurance Corporation of India (LIC)(currently, the largest shareholder with 25% shares) and also to international players like Mitsubishi (through Orix Corporation, Japan) and Abu Dhabi Investment Authority (ADIA).
The crisis of IL&FC began when the IL&FS subsidiary unit of IL&FS Transportation and Networks Ltd failed to service obligations followed by the credit defaulting of Parent IL&FS and other units in July 2018. In the following days, it was announced that they were unable to repay some of the loans and inter-corporate deposits by other banks and lenders, thus setting off a chain of debacles and defaults of multiple subsidiaries on repayment and also a liquidity crisis. To get to the crux of the matter and analyse the implications of such a crisis, it is essential to investigate the shadow banking experience of IL&FS in India and the risks of such non regulated activities on a large scale, but also looking at the constitutional provisions that could have made the matter less dire in its scope and aftermath.
What is Shadow Banking?
Shadow banking is essentially an umbrella term for all those financial activities that take place among non-banking financial institutions which are outside the scope of regulators. It could also be referred to as unregulated financial activities by regulated institutions, like in the case of credit default swaps. ‘Shadow banking include investment banks, mortgage lenders, money market funds, insurance companies, hedge funds, private equity funds and payday lenders, all of which are a significant and growing source of credit in the economy’(Investopedia, 2018). Shadow banks have posed as an alternative to traditional banking especially in developing countries where the NBFCs(Non-Banking Financial Companies) have proved to be better and less stringent at credit deliveries and financial inclusion. However, shadow banking has become a risky phenomenon in countries like India as they operate outside the regulated banking system and financial intermediation is not as transparent as conventional banking systems. The prudence in regulation and management of such institutions were considered paramount, taking into account the potential risks like the cascading effect of insolvency and piling up debt or contagion to other financial markets or a fiscal failure on the part of the government. This is exactly what lies at the core of IL&FS crisis: the systemic failure of management of these financial services, internal governance, credit rating agencies and the regulatory mechanisms. Before discussing this fiasco in detail, it is important to address the current crisis at IL&FS and what the government has done to contain this blight on the financial markets.
The crisis at IL&FS
The crisis at IL&FS is probably one of the biggest threats that our economy has faced in the recent times, with the threat and paranoia of contagion spreading across the financial markets resulting from the defaulting of multiple payments by the financial services as well as a terrible asset-liability mismatch, which led to the liquidity crisis and insolvency issues. In early September 2018, it was reported that one of the IL&FS subsidiaries was unable to repay a short-term loan of Rs 1000 crore to Small Industries Development Bank of India (SIDBI) which led to SIDBI asking one of its officers to resign. Furthermore, a series of defaults had occurred with the IL&FS parent unit and its subsidiaries on commitments including bonds and commercial papers which followed the failure of five special purpose vehicles of IL&FS Transportation Networks Ltd to service obligations in August. Insolvency cases were also filed against the company following the missed payments to banks like SIDBI. This led to a chain of defaults in the IL&FS financial services and it also failed in repaying Rs 450 crore worth of inter-corporate deposits to SIDBI. According to the government, IL&FS has the infrastructure and financial assets exceeding Rs 1,15,000 crore and is currently facing tremendous debt pressure and struggling to service around Rs 91,000 crore in debt, a result of ‘mismanaged borrowings in the past’(Ministry of Finance, 2018). This indiscriminate borrowing of money and hiding the severe mismatch between its cash obligations and payment obligations in its financial statements and the consistently lacking liquidity were the most serious of causes behind the whole crisis.
LIC, the largest shareholder, was expected to save the Company from bankruptcy and seeing that it could hurt the savings of others (and also because of the cascading effect with the stock market going into shock), the government decided to step in and seize control over this financial disaster. The central government, on receiving a report from the Ministry of Corporate Affairs, concluded that the affairs of the IL&FS holding company and its group companies are being conducted in a manner detrimental to public interest. ‘With a view to preventing further mismanagement and protecting public interest, the Ministry of Corporate Affairs moved the National Company Law Tribunal (NCLT), Mumbai, under Section 241(2) read with Section 242 of the Companies Act, 2013 with a prayer to supersede the existing Board and appoint the new Board of Directors with immediate effect. The NCLT, on 1st October 2018, suspended the existing board and directed that the suspended members should not represent the company in any form with immediate effect’. Following this, the central government seized control of IL&FS, by ousting the board of the company and replacing it with the government’s handpicked six-member board led by Uday Kotak(MD of Kotak Mahindra Bank), former IAS officer & Tech Mahindra boss Vineet Nayyar, former SEBI chief G N Bajpai, former ICICI Bank chairman G C Chaturvedi, former IAS officers Malini Shankar and Nand Kishore and recently inducted member, former bureaucrat CS Rajan. This audacious move by the government (like a sudden public take-over) took the investors by surprise and the government also subsequently unveiled an investigation into IL&FS’s management by the Serious Fraud Investigation Office. The government is also expected to overhaul the management and monitor any future restructuring plans. Recently, the National Company Law Appellate Tribunal (NCLAT) on an interim order granted a moratorium for IL&FS, ‘which will stay all proceedings by lenders or companies against debt-laden IL&FS and its 348 group companies in any court of law or tribunal, excluding petitions under Article 226 of the Constitution before any High Court of the Supreme Court’ (The Indian Express, 2018). The moratorium will continue until further orders and this will give the new board of directors the time to come up with a comprehensive resolution plan and will preserve the group assets, according to the IL&FS statement.
Who all are to be blamed?
The Finance Ministry, in a memo, had said that it was concerned that just 28 billion rupees of IL&FS securities owned by mutual funds could set off a chain reaction of redemption by investors. That, in turn, ‘may send sovereign bond yields soaring to 8.5 per cent, a level not seen since 2014, and possibly derail the government’s borrowing plan, according to the note seen by Bloomberg’ (Livemint, 2018). The move by the central government to take control over the company cannot be thus criticized completely as the seriousness of the matter was such that immediate action was necessary.
The financial services wing of IL&FS, which is the borrowing arm of the company, is to be blamed firstly as the company and its different units had been borrowing money in the form of short-term loans and investing it in projects that had long gestation periods which developed a serious asset-liability mismatch in the financial management. Liquidity issues also arise when loans and deposits have different maturities. Depositors have to be repaid when their funds mature, but banks cannot recall their loans. They will have to find new deposits or roll over those maturing or else they will not be able to service their depositors. Also, investors are partly responsible for their misfortune as they were not looking at the underlying project risks when they were blindly putting their money on something that was headed towards a managerial disaster. IL&FS’s original charter was to finance infrastructure and lease projects, but it went on to own its own infrastructure projects and setting up power projects like building roads, tunnels or toll projects. This was also a major mistake of the company but now makes us question why the government is not funding these projects and the sensible answer would simply be that they don’t have sufficient funds or resources to do so, without the support of a quasi-sovereign entity like IL&FS. Another major failure is that of the regulatory agencies like Financial Stability and Development Council (FSDC), RBI and also of credit rating agencies, which should have seen this upcoming crisis long before as the liabilities of IL&FS kept going up at the same time when the credit rating was still solid. The lack of transparency in IL&FS’s dealings is also evident from the actual number of subsidiaries that was revealed to the ministry, which was previously misinformed. Securities and Exchange Board of India (SEBI) has also failed in keeping an oversight on the rating agencies and its washout is evident from the credit rating of IL&FS plummeting from as high as AA or AAA to a D, which is basically like nose-diving from a gold mine to a pile of junk. Anil Singhvi, founder and Chairman of Ican Investment Advisors, is of the opinion that “IL&FS should be a good example and an eye opener for the entire regulatory framework in India. It is not a small deal. It is about Rs 1 lakh crore; I do not have any iota of doubt in my mind that most mutual funds and other lenders to IL&FS failed miserably in having a credit assessment.” So, it is evident that the IL&FS crisis was the result of a systemic failure of multiple agencies and authorities.
Government’s actions and its implications
The government has invoked a lesser-known provision in the Companies Act (Section 241(2)) 2013, in order to sack the board at IL&FS and to bring the financial situation back to normalcy by appointing a new board of directors with high credentials and experience. However, the critical point is that the government had to wait till the last moment to dive in and rescue the economy, which is essentially because of the failure of regulatory systems in our country and also the last-minute financial recovery measures by the RBI, which should’ve stepped in much earlier. However, it also points to a direction which is slightly problematic as the government is devoid of capacity to finance infrastructure projects and hence has to depend on private sector funders (like the IL&FS) that aggregates funds from other debt-market players to finance the infra projects, but also faces the risk of slithering into such maturity mismatch problems or liquidity crises due to long terms projects getting held up in land disputes and other issues.
The immediate solutions to such crises would be the intervention of government and backstopping the huge debts. But in the long run, close and careful supervision and regulation are paramount and such failures must be foreseen and dealt with at the right time, systematically. One way of backstopping such huge debts and financing more infrastructure projects would be to issue a superior debt equity instrument to the National Investment and Infrastructure Fund (NIIF) to be repaid first, according to Raghav Bahl. NIIF is the sovereign wealth fund that only raises capital from long-term investors and 51% of it is owned by the government. But this only reduces the problem of financing infrastructure as the government still has to put in the majority of money. The private sector, invariably, has a lot of scope in putting more resources into figuring out what’s worth building and what is not. Even though the asset-liability mismatch is bound to have consequences on the Non-Banking Financial Companies(NBFCs), the market will soon come back to a normal state of affairs if the finances are handled carefully and supervised systematically. Yet, the importance of an ideal legal framework to deal with such insolvency issues and crises is paramount and is currently absent in our system. With a new failure to learn from, it is hoped that the government as well as other agencies, financial and regulatory, will be better prepared in the future to face the inexorable failure of NBFCs.
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Livemint. (2018): The untold tale behind government’s shock takeover of IL&FS. Livemint. Retrieved from: https://www.livemint.com/Industry/W1yKVh8sqjqrH7mLORXWqO/The-untold-tale-behind-governments-shock-takeover-of-ILFS.html
Manghat, S. (2018). How much IL&FS think it’s worth. Bloomberg Quint.
Sharma, S. M. (2018). Behind the IL&FS crisis: India hasn't a clue how to pay for infrastructure. Business Standard. Retrieved from: https://www.business-standard.com/article/finance/behind-the-il-fs-crisis-india-hasn-t-a-clue-how-to-pay-for-infrastructure-118100300299_1.html
Verma, S. (2018). Appellate Tribunal order: NCLAT grants interim relief to IL&FS against creditor actions. The Indian Express. Retrieved from: https://indianexpress.com/article/business/companies/appellate-tribunal-order-nclat-grants-interim-relief-to-ilfs-against-creditor-actions-5403667/
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