IL&FS debacle – Have the lessons from the 2008 Global Financial Crisis been learnt?

September 2018 marked the 10^th anniversary of Lehman Brothers’ collapse and one can’t be faulted for thinking that the regulators would have upped their game by learning from that experience and implemented sufficient regulatory safeguards to avoid a similar situation requiring a taxpayer funded bail-out of some shape or form.

But the reality hit hard for several Indian investors when India's leading infrastructure finance company IL&FS defaulted on payments to its lenders triggering a minor panic in the markets.

Infrastructure Leasing & Finance Services (IL&FS), is an investment holding company with business operations through separate companies which form an ecosystem of investments across infrastructure, finance and social and environmental services.  IL&FS was founded in 1987 with equity from Central Bank of India, Unit Trust of India and Housing Development Finance Corp to fund infrastructure projects.  Besides this, IL&FS has institutional shareholders including SBI, LIC, ORIX Corporation of Japan and Abu Dhabi Investment Authority (ADIA).  As on March 31, 2018, LIC and ORIX Corporation are the largest shareholders in IL&FS with their stake at 25.34 per cent and 23.54 per cent, respectively. Other prominent shareholders include ADIA (12.56 per cent), HDFC (9.02 per cent), CBI (7.67 per cent) and SBI (6.42 per cent).  Another important investor in the company is the Employees Wealth Trust (EWT) owing about 12% stake, which is now at the centre of the storm owing to several sweet deals executed by it to enrich a small group of senior executives. This reeks poor Corporate Governance standards where the executive management was brazenly securing deals for the benefit of a small cabal of senior executives.

What caused the panic?

IL&FS Financial Services, a group company, defaulted in payment obligations of bank loans (including interest), term and short-term deposits and failed to meet the commercial paper redemption obligations due on September 14. On September 15, the company reported that it had received notices for delays and defaults in servicing some of the inter corporate deposits accepted by it.

Consequent to defaults, rating agency ICRA downgraded the ratings of its short-term and long-term borrowing programmes. The defaults also jeopardised hundreds of investors, banks and mutual funds associated with IL&FS. 

·         The rating agencies downgraded the long-term ratings of the parent entity IL&FS multiple notches from AA+ to BB on 8^th September and then to D on 17^th September.

·         The short-term rating was also downgraded from A1+ to A4 on 8^th September (4 notches on a single day!) and then to D on 17^th September.

This is not normal for any issuer and is usually the jump-to-default cases are rare. This points to the weakness in the rating agencies standards and their lack of rigour as such a sharp downgrade in a single review shows that they failed to pick up early signs of weaknesses in their liquidity risk management. 

This may also call into question the sanctity of the ratings of other bond issues and it is likely that several other issues may face downgrades when the rating agencies pull their socks up and conduct a thorough review and tighten their ratings criteria.

Market Impact

What followed its default was a knock on effect on several mutual funds that had exposure to IL&FS and its group companies in their portfolios. The Mark to Market (MTM) impact on these bonds, resulted in a sharp drop in NAV of many of these funds. While bond prices move as a result of credit spread changes, the speed and the extent of the downgrades hit their holdings hard and the pain may yet continue due to a contagion effect. As many of the funds will have an investment mandates to hold bonds of issuers above a certain ratings threshold, further sell-offs are likely to keep the bond prices low.  Besides Funds, several Public-Sector Banks have exposure in IL&FSs bonds and loans (~$ 2.5bn) and the impact of the failure of IL&FS will have a telling effect on an already weak banking system which will further impact credit growth that may slow down the economic growth.

The Bail out

The Life Insurance Corporation of India (LIC) is expected to once again come to the aid of a distressed ‘systemically important’ firm (after bailing IDBI recently) as struggling infrastructure major IL&FS is set to receive some form of financing from the insurance major. LIC, which holds the largest stake in IL&FS, is expected to purchase IL&FS’s non-convertible debentures.

What ails IL&FS? 

IL&FS is afflicted by several factors, the principal ones being poor Corporate Governance and even poorer regulatory oversight.  NBFCs have been performing shadow banking services, yet the regulatory regime was inadequate for the systemic risk that they collectively pose to the regulated banking sector and to the wider economy.

The management of the company is facing several allegations:

·         Poor overall risk management disciplines in general and liquidity and funding risk management in particular (excessive maturity transformation, leverage)

·         Poor corporate governance especially around disclosure of conflicts of interest

·         Enriching a small group of employees at the expense of the company

·         Nepotism by offering jobs to family, friends and relatives

As infrastructure became a prime focus for successive governments in the past two decades, IL&FS, with its prime mover position in this segment secured several of these projects. Over time, the company funded its growth through a series debt issuances and commercial borrowings which resulted in a leveraged Balance Sheet with debt-to-equity of ~17 and resulted in over 169 subsidiaries at last count.

While this in itself may not have posed as much trouble if the projects went on-stream in a timely manner allowing for mini-perm refinancing to kick-in, the delay in execution of projects and the consequent delay in cashflows required to service these debt issuances was severely dented.  This adverse cashflow position was further compounded by excessive maturity transformation that added to the funding requirements as repayment of maturing debt came in quick succession.

The Group has a debt of about $12.5bn (Rs. 91,000 Crore) of which about $5bn (Rs. 37,000 crores) is short term and due to mature within a year.  About $9bn (Rs. 60,000 Crores) of the debt is project specific, including road, power and water projects.

As the nature of business is long term projects and capital intensive, the business model is predicated on refinancing of projects (mini-perms) as risks are mitigated with project completion and revenues are stabilised. A major reason for delays in project execution was due to the complications and delays in land acquisition which is an endemic issue in infrastructure projects.

The 2013 land acquisition law also made many of its projects unviable as the compensation for land acquisition increased considerably. Delays in project completion, cost escalation and poor funding profile led to a squeeze on its resources besides poor risk management that did not consider the consequences of several incomplete projects. Lack of timely actions to stabilise and diversify funding exacerbated the problems. 

Regulatory landscape - RBI regulations on Asset Liability Management (ALM)

While maturity transformation is an important part of financial intermediation as it contributes to efficient resource allocation and credit creation, the risks associated with it needs to be carefully monitored and managed with sufficient safeguards in the form of contingency funding actions.

The RBI had put in place Asset Liability Management (ALM) regulations for Banks in 1999 and for deposit taking NBFCs in 2002 (DNBS (PD).CC.No.15 /02.01/2000-2001 dated June  27, 2001) which was expanded to cover all NBFC in 2011.

The regulatory requirements currently require submission of liquidity maturity mismatches for various tenors with a mismatch cap for the first month at 15% of cumulative outflows within one year.  This kind of blunt approach considers neither the unique funding needs of a business model nor its funding profile, allowing for excessive maturity transformation.

The regulations governing NBFCs are not fit for purpose and the risks have been accentuated further by inadequate regulatory oversight.  The lack of appropriate regulations to mitigate funding and liquidity risks allowed for these risks to mount unchecked.  The rating agencies also failed to assess these risks as their approach places excessive reliance on Parental Support (Qausi-sovereign) which allowed them to assign high credit ratings.  This further contributed to the complacency within the system that allowed several mutual funds to invest in IL&FS bonds as it met their investment mandate.

Basel 3 liquidity regulations

Basel and other regulators like the EBA, PRA developed liquidity regulations in the wake of Lehman collapse to address risks emerging from excessive maturity transformation. In order to address both short term and structural liquidity risks, Basel developed a framework for short term risks with its Liquidity Coverage Ratio (LCR) with its BCBS 238 and the Net Stable Funding Ratio (NSFR) for structural liquidity risks.  The Basel guidelines for LCR (BCBS 238) was issued in September 2013 and was effective from January 2015 with transitional provisions up to 2018 and for NSFR (BCBS 295) in October 2014 effective January 2018.

RBI followed the BCBS guidelines on LCR for Banks in June 2014 (DBOD .BP.BC.No.120/21.04.098/2013-14) and NSFR in May 2015 (DBR.BP.BC.XX/21.04.098/2014-15) with similar timeline and transition provisions.  It is important to note that none of these applied to shadow banking world of NBFCs which perform similar functions to that of a Bank except for its deposit taking activities. 

NBFCs have largely relied on funding from banks and capital markets for its core business assets besides public deposits in some cases.  Collectively they pose a systemic risk to the banking sector and to wider economy.  RBI making an exception for NBFCs from complying with these liquidity regulations was imprudent.

What next?

One might wonder what is the great hullabaloo over a debt of $12 billion? As many of these debt is owned by public sector banks and mutual funds, the potential of a contagion is significant as that will lead to further deleveraging resulting in an even slower credit growth.

As an immediate step, the government sacked the current board and replaced it with a new seven-member board headed by Uday Kotak, MD and CEO of Kotak Mahindra Bank.  This should be followed up with an independent forensic investigation is required to ensure there is no conflict of interest in the investigations as well as to determine the impact from conflict of interest that allowed the senior management to enrich themselves.

But these actions alone will not be enough.  Several other steps are required to put the NBFC (and the banking sector) on a firmer footing.  These include, but not limited to:

1.       Appointment to the Board of significant financial institutions to require financial risk management domain expertise and should not be used to reward pliant bureaucrats

2.       Enforce high level of Corporate governance standards and conflict of interest rules.  Conflict of interest is endemic within the financial sector and needs to be stamped out with a vengeance.

3.       Enhance liquidity risk regulations on NBFCs by tightening the ALM framework and imposing LCR and NSFR requirements

4.       Stipulate stringent stress testing standards to assess capital and funding requirements under stress and impose sufficient counterbalancing capacity requirements in the form of capital and liquid asset buffers.

5.       Finally, hold Rating agencies to account by reviewing their ratings criteria and practices.  They cannot continue to rely on parental support of quasi-sovereign entities to support a higher credit rating. 

In conclusion, RBI needs to up its game and tighten its Supervisory regime of the financial sector.  This is not merely about issuance of regulations but requires follow up with a Pillar 2 - Supervisory Review Framework that examines the risk management framework and disciplines of major financial institutions in a more systematic and programmed manner.  If the RBI has inadequate skilled resources to conduct such reviews, it should seek external support of experts to perform such roles on its behalf, much like the Section 166 - Skilled persons review by the FCA in the U.K.