India’s near-Lehman moment: The crisis at IL&FS must be used to address fault lines in the financial sector
Starting with a default on its Rs 1,000 crore bond repayment to Sidbi (Small Industries Development Bank of India), IL&FS and its non-banking finance subsidiaries have begun to renege on one repayment after another. By Friday last, fears that mounting troubles in the IL&FS group might be symptomatic of larger problems in the non-banking finance company (NBFC) space and, in turn, pose a serious threat to financial stability saw markets plunge more than 1,100 points intra-day.
The unstated fear was that thanks to its inter-linkages with the financial system IL&FS, like Lehman before it, may drag the entire financial system and the larger macro-economy down with it.
For now the storm seems to have abated. Latest reports speak of Orix Corporation, the diversified Japanese financial services company and one of the largest shareholders in IL&FS, being willing to up its stake; of government and RBI pitching in to help with speedy sale of IL&FS assets. But these are only band-aid solutions that cannot, and will not, last. We need to look deeper and address the cause, rather than the symptom, of the disease.
“Never waste a crisis,” said Rahm Emanuel, former US President Barack Obama’s Chief of Staff. Sound advice! The crisis at IL&FS has exposed a number of fault lines. To begin with, the ills of the financial sector go much beyond the much-maligned public sector banks. It is the familiar story of failure on multiple fronts: the regulator Reserve Bank of India (RBI), credit rating agencies who downgraded IL&FS much too late, auditors, and most importantly, the board of IL&FS.
Take these one by one. IL&FS is a ‘Core Investment Company’, a holding company, whose operations are restricted to investments in group companies. It is registered with RBI as ‘systemically important’, that is its financial health has ramifications for the financial system and the economy. Given that one of the biggest learnings of the 2008 crisis is of the dangers posed by shadow banks like IL&FS, one would have expected RBI to keep a close eye on IL&FS, particularly in view of its excessive leverage. But, sadly, it failed to do so!
If RBI bears the main responsibility for the unfolding events at IL&FS, it is not the only one. Rating agencies have, again, been caught sleeping on the watch. Ratings have been rapidly downgraded; in many cases after the event.
The problem goes deeper. Rating agencies are technically under the Securities and Exchange Board of India (Sebi); but are not subject to close regulatory oversight. Worse, under the current rating model, fees are paid by the rated entities. There is, thus, a huge incentive to give generous ratings for fear of losing business. Until we address this basic flaw in the rating model, ratings must be taken for what they are worth: very little!
Company auditors are no less culpable. The annual accounts of IL&FS and its close to 200 subsidiaries were audited by some of the biggest names in the profession. Yet none thought it fit to red flag the growing dependence on short term debt and the excessively high leverage.
The biggest opprobrium must, however, be reserved for the board of IL&FS. As with Satyam Computers and more recently ICICI Bank, IL&FS had a star-studded board. Yet Ravi Parthasarathy, CEO from 1989 till July 2018, seems to have run the company like his fiefdom. Not only were no questions asked, so it would seem, he was handsomely rewarded for presiding over the virtual destruction of IL&FS. According to the latest annual report, his last annual pay was close to Rs 25 crore – 141 times the median salary of the IL&FS employee.
Each of these entities, RBI, rating agencies, auditors and the board, must share the blame and take corrective measures. But there is a larger factor at play that must be factored in while considering any kind of rescue package: the inherent flaw in the extant model of infrastructure financing. This makes any short-term solution akin to kicking the can down the road. Infra projects have long gestation periods. They require long term funding that neither banks nor NBFCs can provide.
Moreover, issues related to land acquisition, environmental clearance, policy flip-flop, political interference and rapidly changing external dynamics make infrastructure financing particularly risky. Cost and time overruns are inevitable. Unless we address these we will not be able to ring-fence either banks or NBFCs from the risk associated with financing infrastructure. Look no further than to the erstwhile IDBI, ICICI and IDFC that were initially set up as term-lending institutions and then had to be converted into banks to save them from going down under.
It is imperative that before we consider any solution, especially bailout with taxpayer money, RBI must make an informed assessment of IL&FS’s inter-connectedness (and, hence, risk of systemic failure). Remember, any solution will prove short lived unless we address fault lines all around, including underlying risks in infra financing.