The IL&FS Fiasco – Detailed Analysis, What went wrong and What’s the way ahead?

An IIM Ahmedabad Alumnus as  Chairperson and Managing Director, London School of Economics masters degree holder as vice chairman, Senior-level executives of reputed international investment companies, a no. of Chartered Accountants and many more with over 30 years of experience and having served in reputed organisations in India and across the Globe- Do the above people seem overqualified?

Well, to give you the fact here the above was the board of IL&FS which recently defaulted on their commercial papers, bonds, inter-corporate deposits, non-convertible debentures and do you know that these were rated as extremely safe investments by the credit rating agencies?

Such an exquisite infrastructure and financing company, with over 169 subsidiaries which had undertaken major infrastructural projects in India now has only $27Million in hand and repayment obligation of $500Million over the next six months!

Are you still sitting there in shock and not able to get what exactly happened here?

Then don’t worry because we have got you covered here and will take into account all your queries!

Because in today’s Indian Economy, IL&FS has become more than a buzzword and everyone wants to know how such a seemingly sound financial company suddenly became one of the biggest defaulters?

Let us explore the reasons one by one here!

Asset-Liability Mismatch

When you lend more than the money you have or your credit collection period is longer than your loan payback period, then you are in a situation of an asset-liability mismatch. Let us take an example to make the concept more clear here.

Let us say that a company had given a loan for a 2 year period but had to pay back on loans taken by it in 1.5 years, then there is an asset-liability mismatch.

How will you pay back something which you expect to receive later?

This is a reason why there are rising NPA’s in the public sector banks and recently a similar thing happened under this IL&FS Fiasco.

There was also a liquidity crisis in the company.

The debt of IL&FS has nearly doubled over the past 4 years but the assets haven’t risen to that extent.

They defaulted on their commercial papers, bonds, inter-corporate deposits, non-convertible debentures and mind you, they were rated as extremely safe! Although this seems incredulous yes, this has happened! What were the credit rating agencies doing? Let’s proceed to analyze them.

Credit Rating Agencies

Should the credit rating agencies relied upon?

The rating of IL&FS was dropped down from AAA(Highly Secure) to D(Default) by the credit rating agencies in a mere 45 days. What caused the agencies to rate the defaulting company so high in the first place? What about periodic reviews of the company’s conditions?

The same happened under the US 2008 financial crisis, wherein large investment banks were given triple-A ratings and the sub-prime mortgages were also rated triple-A.

A pertinent question hence comes to one’s mind- How are these ratings determined and what are the current shortfalls?

Credit Rating Agencies Role

They conduct research on the credit quality of an instrument and provide their opinion. They are just an indication of asset quality. They don’t guarantee that their ratings will be 100% accurate as the future is unpredictable.

Their ratings are based upon historical and present information and hence provide a future outlook of a company or asset.

According to them, they just help the investors or mutual funds in undertaking investment decisions and determination of the quality of the assets, but if the rating is not accurate and the company fails, they are not legally liable for it!

How are Ratings Determined?

The ratings are determined after undertaking a multitude of factors into accounts, such as the current management of the company, financial stability, cash flow position, assets, and profits. The analysis offered by these agencies is not dynamic and hence can give a shock to investors whenever there is a sudden investment downgrade.

What has the RBI done in this regard?

Reserve Bank to hold joint audits of credit rating agencies with SEBI and examine the bond spreads, which the credit rating agencies don’t take into account as of now.

A bond spread is typically the difference between different bond yields. For example, if the Indian Government is offering a yield of say 8% on its bonds and IL&FS offers a 10% yield then the spread is 2%.

The higher the spread, the, riskier is the investment as it offers a higher return to investors. 

Henceforth, the central bank wanted the credit rating agencies to analyze the high bond spreads of companies in determination of Ratings, so as to provide an accurate analysis of the financial stability of a company.

 Management and Changing Financial Status

Senior Management had started getting out of the company in the last two years.

 These were signs that a seemingly sound financial company may not be as sound as it seemed on paper.

The management was clearly aware of the grave situation the company was in and decided to cash out when they got the opportunity. Such a fiasco isn’t an overnight process.

There are hundreds of decisions taken over a period of time which had determined the current state the company is in.

 Also, as per the company’s annual report, its former Chairman had got a raise of 144% as against an average annual raise of 4.44% for the rest of the employees, he was drawing a compensation in excess of ₹ 26 Crores.

The amount of dividend paid by the company on shares fell from over ₹160 Crores to ₹65 crores, over 50% Decrease in the last financial year.

The fiasco, India’s Lehman moment obviously comes out as a shock to the government and investors as they didn’t even get a whiff of what happened!

IL&FS was a systemically important NBFC, that is a company whose failure can affect the entire economy.

These were warning signals and should have been looked upon by the Credit Rating Agencies, Mutual Funds and especially the government, which is holding over a 25% stake in it.

 The increasing influence of the Shadow Banking Industry

Shadow Banking is a growing source of credit for the economies. They are subject to minimal financial regulations due to the way in which they accept their deposits or give loans. Non- Banking Financial Companies(NBFC’s) such as IL&FS are also part of the shadow banking industry.

As per RBI’s financial stability report, there has been increased leverage in the NBFC’s, share capital has reduced from 19.9% to 8.3% while the total borrowings have increased from 14.6% to 21.2%.

Indian Economy’s dependency has increased heavily in the above Industry.

Credit Suisse has estimated that 41% of the borrowings of the NBFC’s are maturing in the next six months adding to further liquidity pressure to refinance the above industry.

The Effect on the Mutual Fund Industry

Now, the mutual fund industry is the one that has been widely affected by this fiasco. More than ₹ 2500 Crore of the Industry was exposed to this company and hence it posed a systemic risk.

Ultra Short Term and liquidity funds were the most affected. In fact, Motilal Oswal MF had stopped accepting investments in these categories of funds after the fall.

Had your mutual fund invested in IL&FS and should you be worried? Read more here-

Aditya Birla Group has the biggest exposure at about ₹ 1,524 crores. Mutual Funds have experienced heavy losses on their NAV’s as they had to exit IL&FS after the rating downgrade by credit rating agencies in order to protect their own reputation. 

The credit ratings of the companies play a pivotal role in the way mutual fund managers select their holdings for ensuring maximum returns with a minimal amount of risk involved. But, that is not the only criterion that is to be relied upon.

This raises a serious question on the seemingly extensive research done by the mutual fund companies on IL&FS.

Do we see a certain pattern being formed?

IDBI bank had defaulted and the government had decided to pare the stake of LIC in it to 51%. The merger of Bank of Baroda, Dena Bank, and Vijaya Bank was also for the survival of these banks.

There are serious troubles in the Indian Economy. The increase in the stake of LIC in IDBI was clearly a bailout by the government. Increasing defaults, poor asset quality, bureaucracy, Red-Tapism are they eating up our economy?

These are warning signs and should be looked upon carefully. It is an alarming situation and the correct time to act upon is now, it is never too late. But, we as the citizens don’t know how the grave the situation is.

A thorough analysis, looking beyond the information given to us, connecting the dots is what will lead us to such questions raised above and what may be the best criteria to resolve them.

With the election year coming up and rising no. of defaults on a regular basis, there doesn’t seem to be a long term plan in place for the next year at least.

Immediate Relief is being provided and steps are being undertaken, but unless the root of the problem is identified then maybe we may keep on facing these impending shocks and forming committees, short term reliefs may not come out to be a feasible option for time to come.

Way Ahead for IL&FS

The Government has recently formed a six-member committee lead by Industry stalwart Uday Kotak, which has replaced the current IL&FS board and will form a resolution plan.

They would submit their report to the NCLT (National Company Law Tribunal) for review this month.

The company’s shareholders had also approved a plan for restructuring through raising Non-Convertible Debt and equity of Rs.4500 crores.

Is the above solution of replacing the current board and forming a resolution plan good enough?

Or should the government bailout IL&FS by using taxpayer’s money, in order to reduce the systemic risk imposed above by IL&FS and save the mutual fund industry?

Leave a Reply

Your email address will not be published. Required fields are marked *


© 2021 eveningstar