How IL&FS Crisis Led to Panic in the Indian Domestic Market

What Went Wrong?

Due to a lack of funds, IL&FS Financial Services could not meet its obligations. IL&FS' active projects experienced cost overruns due to land acquisition and permission delays even as new infrastructure projects stagnated. 

Additionally, it failed to meet its promises to repay bank loans (besides interest), term and short-term deposits, and commercial paper. It stated that it had received statements for servicing some of the inter-corporate deposits it had taken late and in default. ICRA, a rating agency, reduced the ratings of both short-term and long-term borrowing programmes due to defaults. 

With hundreds of investors, banks, and mutual funds connected to IL&FS, the defaults also instilled fear among equity investors and put other non-banking financial institutions in danger due to a default scare.

The group had a debt of 94,000 Crores.

Causes of the Crisis

IL&FS has piled up too much debt in the short term, while revenue from its assets has been skewed to be generated in the longer term.

Main Reasons for the crisis were-

• Structural Defaults

The foundation of NBFCs structure is flawed. That puts it at risk for both financial and project concerns. IL&FS, where it all began, is an example of a parent company that does business through its subsidiaries. It implies that it invests in those subsidiaries which invest in undertaking projects.

Although dividends, interest payments, and other types of payments are typically assumed to flow back to the Parent Company, the crisis caused a backlog in these payments, which impacted the entire company.

• Layer After Layer of Debt

In contrast to the parent company's equity capital of just Rs. 9.83 crores, the IL&FS group accumulated a monstrous debt totalling Rs. 91,000 crores. Debt is raised by the parent firm and invested as equity in each subsidiary.

Additionally, the subsidiary employs equity, a debt on the parent's books, to raise additional debt.

• Assets-Liability Mismatch

The leading cause of this problem is a negative assets-liability mismatch, which occurs when assets come in lower than liabilities go out. As a result, the NBFCs borrow money for 8 to 10 years before investing in projects with a gestation period of 10 to 15 years.

Yet, because of RBI refinancing requirements, businesses were compelled to issue CPs and debentures to borrow money from the market.

A significant asset-liability mismatch resulted from taking out loans for a shorter time while investing in long-term assets.

• Unviable Projects

The NBFCs' investments in unsustainable projects have significantly impacted the crisis. Road, power, and water projects are included in the almost 60,000 Crore in debt that IL&FS alone owes at the project level.

Many projects were left unfinished due to difficulties in land acquisition, delays in environmental approvals, and cost inflation. Many issues, including a lack of prompt action, delayed this project.

Impact of IL&FS Crisis on Indian Economy

The following was the notable impact of IL&FS Crisis on Indian Economy-

• On Independent Investors

The worst affected were investors, including mutual funds, people, banks, and other corporations, who offered a loan through inter-corporate deposits since IL&FS began to raise enormous sums of funds from the market through commercial paper, an unsecured debt aimed for quick finances.

• On Infrastructure Projects

The IL & FS issue will significantly impact ongoing infrastructure projects. For instance, government officials in Maharashtra believe that the IL&FS crisis is to blame for banks' reluctance to provide financing for the continuation of construction of the Mumbai-Nagpur Communication Expressway.

Because of the crisis, banks became reluctant to release finances for infrastructure projects. Moreover, IL&FS's ongoing projects, some of which took the shape of a PPP model (Public-Private Partnership) for constructing national routes and connecting roads, furthermore suffered a severe setback.

• On Credit Rating Agencies

The crisis highlighted the credit rating agencies' lack of transparency and accountability and perversion of the ideals of prudence, caution, and absolute integrity. After the situation, the government strengthened its control over credit rating companies and increased the penalty for fraud.

• On the NPA Crisis and Its Effect on the Economy

A severe funding shortage following the crisis in 2018 led to NBFCs experiencing a liquidity crisis.

Following the crisis, NBFCs struggled mainly due to Infrastructure Leasing and Financial Services demise (IL&FS). As a result, investors withdrew substantial sums from significant NBFCs, especially housing lending institutions.

As flexible loan facilities are essential for well-rated NBFCs, the RBA announced provisions in its February 2019 policy to ensure this. It was done due to the RBI tightening NBFC credit standards and making bank exposure for lending rating-dependent.

• Management Concerns

The NBFCs' management overvalued the company. The administration of NBFCs should have taken corrective measures despite RBI raising questions. It sparked more doubts about these businesses' openness, responsibility, and corporate governance.

• Rating Agencies’ Credibility

The fact that the credit rating agencies assigned "AAA" ratings to the securities and could not identify the problem because of insufficient analysis and investigation into the industry speak highly of their reliability.

• Regulation

Unlike conventional banks, NBFCs are not tightly regulated by the RBI or any other organization. However, the administration of these organizations has come under scrutiny in the wake of the IL&FS disaster.

Conclusion 

The liquidity problem doubts public regulatory authorities and NBFCs' ineffective corporate governance. Moreover, the liquidity crunch severely impacted the economy and industries that significantly rely on NBFC lending, like commercial real estate, consumer durables, and cars.

The consumption will decline even more, undermining growth, if the liquidity crisis continues. Moreover, restoring investor trust is necessary because they are concerned about leverage at other shadow banks, which has increased volatility among financial stocks.

Disclaimer: This blog is solely for educational purposes. The securities/investments quoted here are not recommendatory.