IL&FS is a PSU formed under RBI registered Core Investment Company i.e. an NBFC. It was formed to finance the major infrastructure projects in India. Initially, the Central Bank of India, UTI and HDFC held majority shares in the company. As the number of projects increased and the need for funds increased, the company acquired foreign investment as well. Equity investment came from the Abu Dhabi Investment Authority and Orix (a Japanese company). Later, LIC also acquired a 25% stake in the firm.
What triggered the company’s downfall? Despite it’s powerful and smart shareholders and although they had big projects lined up?
A default on the short-term loans taken from SIDBI signaled that all was not well with ILFS. There were multiple reasons that led to the crises. Some of the causes, in brief, include tenure mismatch-short term loans that were used to finance long term projects. This was despite the board of directors overseeing project selection and planning. There was also round-tripping of loans-loans given to 3rd the party was transferred back to IL&FS subsidiaries. This raises doubts over transparency at the firm.
The problem was exacerbated by the fact that the company was lending at losses with a spread between 7/8 %- if interest was charged it was charged at a nominal value. Specious loans were disbursed to historical defaulters, even though the Internal Risk Management Committee had raised red flags. Collaterals didn’t cover the loan amount. Apart from these managerial frauds, there were other factors that didn’t favor IL&FS. Sixty Thousand crores of project-level debt, with projects in roads, power, and water. Another major reason behind the trouble in IL&FS was complications arising out of the amended land acquisition law. The 2013 land acquisition law made many of its projects unviable.
Implications of the IL&FS scandal from three major dimensions:
Markets-A week prior to the public announcement of a default, DSP sold off shares of Dewan Housing Finance Corporation Ltd. at a discount, simultaneously the former CEO of Yes Bank, Mr. Rana Kapoor wasn’t granted a tenure extension. A culmination of festering negative sentiment and the revelation of the scandal stimulated the publics\’ animal spirits. As a consequence, there were market losses of 0.8% that week. Financial services comprise a major component of the share market. The idea that a credible company created such a default led many experts to compare similar firms in the space, this led to a drop in share values of financial services shares. Over the duration of a year, large institutions like NABARD, Jio, SAIL cut back on their exposure to credit risk from 4.5lac crore to 3.5lac crore in one year ending June 2019. A cumulative reduction in exposure to risk was about 25%. While most experts remained dismal about the financial services, others were bullish. A few comments made by foreign investors pointed to a necessary structural change that was bound to take place. Over a year, investors shifted their capital to companies with cleaner loan books. Bajaj Finance rose 57%, PFC rose 57% while Indiabulls Housing Finance fell by 50% and Aditya Birla Capital fell by 30%.
It is interesting to note that the NPA and leverage ratio of shadow banks increased year over year from 2015 to 2018. Table 1 below details how as capital adequacy ratio decreased, the corresponding NPA percentage grew. Whereas, the growth of loan rollout by NBFC’s this year has decreased to a more sober 19%.
Table 1: Growing NPAs vs. Leverage Ratio
NBFCs- With the public announcement of the default, ICRA downgraded the credit ratings of several bonds (including IL&FS from AAA to D). This revision led to a reluctance to lend to IL&FS and similar firms. IL&FS, in particular, faced a credit shortage. Repeated poor project selections and growing debts led to a large asset to liability mismatch in the industry. As a result, credit was growing at near its slowest pace in 20 years The ripple effect has stalled building projects, starved wholesalers of loans to buy inventory and prevented farmers from borrowing to buy tractors and motorbikes.
Recently, the government eased lending norms and exposure limits through a one time six-month credit guarantee to high rated NBFCs up to Rs. 1lakh crore for the first loss of up to 10%
Institutional level- RBI issued a warning to the IL&FS when it failed to pay upon its commitments in the month of September 2018. Further, as a consequence of poor performance that the RBI imposed strict norms on NBFCs with greater supervision and regulation. They also gave stricter directives to the Finance Industry Development Council, the umbrella organization of NBFCs
It was well known to the incumbent Board of Directors that there was heavy borrowing, the directors were in the process of refinancing, asset sell-off but they ran short on time and their short term commitments came a-knocking. At the same time, the board received all its bonuses and paychecks.
This led to a classic takeover of the Board by the government. At the moment the Uday Kotak led firm is looking to sell off its assets and refinance its debts. For each asset, the firm must approach the court for approvals and each selloff is a long and tedious process as it leads to the firm having to look at the individual project in great detail. For example, the Noida Toll, majorly owned by IL&FS is in a tiff with the Noida Residents Welfare Associate and has not received its toll for over a year. 100s of such assets need to be resolved.
The company also sought Rs.3500crore from the sale of shares and Rs.4500 crore in working capital. LIC expressed an interest in bidding for the same. A structured plan to get the firm back on its feet is underway.
The government continued to pay its sovereign bonds on behalf of the firm to its foreign creditors in order to maintain strong credibility and low default riskiness. The NBFC crisis lead by IL&FS, and its domino effect on the Indian Economy:
Due to the crisis, the people who were the worst hit were the debenture holders (such as pension funds, mutual funds, and the lenders, mostly NBFCs) of the company. According to the reports, 40% of the total financing in the year before the crisis was done by the NBFCs, and up to 45% at the time of the crisis. Many private and state-owned companies invested in the IL&FS bonds under provident fund schemes in anticipation of good returns for their employees. But most pension funds were invested in unsecured bonds, which defaulted at the time of redemption, and debt instruments with high-risk exposure. Reports said that total exposure of IL&FS in pensions was about 10 crores. Mutual fund companies invest in the commercial papers of NBFCs for 90-120days. They would then float the instrument in the market. But because mutual funds got hit by the IL&FS scam, they stopped their funding to the NBFCs and had to release funds to honor the maturing instruments. Because of this, the continuing rippling effects could be seen in the economy.
1.Fall in the GDP:
The crisis happened around the last quarter of the year 2018, which saw a decline in the consumption and financing activities. Subsequently, there was a fall in the GDP in the first quarter of the year 2019.
2.Liquidity crunch in the market:
Market representatives approached the government regarding liquidity problems prevailing in the market. In lieu of such considerations, the RBI cut interest rates. The government claimed that the liquidity problem in the banking sector was resolved. In reality, the primary suspects of the crunch, the NBFCs were largely in dire straits. Most of the lending was done by NBFCs and not by the banks. NBFCs had withdrawn 3 lakh crores from the market to pay their liabilities.
3.The drop in Auto Sales:
The NBFCs had no funds to lend further aggravating liquidity problems in the market. And this problem became more evident when there was a lack of demand for cars and autos. Reports say that 95% of customers preferred loans from NBFCs because of ease of getting credit.
4.A slump in Real Estate:
Real estate firms mostly depend on loans for project finance extended by the NBFCs due to reduced lending by banks. Post RERA Act these companies were unable to divert the owner’s money towards the repayment of the loans, hence they were also dependent for working capital requirements. After the crisis the real estate companies were stuck with projects at hand with no funds, resulting in shut down.
The ILFS case once again brought to the fore issue of mismanagement and lack of financial prudence by firms in this space. Even the watchdogs of the Indian economy failed to predict the crisis. The regulators have as usual followed the band-aid approach in containing the crisis but much more needs to be done. In this regard, Government decision to replace the directors and to take control of the situation was appreciated. However, the cascading effect it had on other sectors of the economy coupled with slowing down of the economy, weak credit growth will take a long time before it recovers and puts the economy back on track.
References:
1. https://m.economictimes.com/industry/banking/finance/banking/everything-about-the-ilfscrisis-
that-has-india-in-panic-mode/articleshow/66026024.cms
2. https://m.economictimes.com/industry/banking/finance/a-year-after-ilfs-collapse-debtdestruction-
and-dithering/articleshow/70868024.cms
3. IL&FS website for details on projects, management and annual report
4.Wiki: IL&FS
5. https://m.economictimes.com/wealth/personal-finance-news/defaults-aplenty-what-is-ailingindias-
nbfc-sector/articleshow/70001015.cms
6. https://www.livemint.com/industry/banking/the-ripple-effect-of-the-nbfc-crisis-on-theeconomy-
1557242882381.html
7. https://m.economictimes.com/industry/banking/finance/banking/shadow-bank-crackdownaccelerates-
in-india-amid-cash-squeeze/articleshow/70779922.cms
8. http://www.forbesindia.com/article/boardroom/ilfs-the-debt-pyramid/51489/1
9. https://www.fortuneindia.com/enterprise/government-takes-charge-of-ilfs/102534
10. https://www.economist.com/leaders/2019/10/10/the-risks-from-indias-rotten-banks
11. https://www.economist.com/finance-and-economics/2019/10/10/indian-banks-share-pricesare-
being-hammered