Story Of The Week

IL&FS’s TIPPING POINT

The problem is not the loss of money or credit, its the loss of trust

                                                                                                                       -David Perry

With NPA(s) being the talk of the year, Indian financial sector has become glaciers, with a river flowing beneath. One wrong move and we all go down. The latest entry in the infamous default macabre is Infrastructure Leasing & Financial Services. IL&FS is a Non-Banking Financial Company, which essentially means a company registered under the Companies Act, 1956 engaged in the business of loans and advances, acquisition of shares, stocks, bonds, debentures, and securities issued by Government regulatory authority.

HOW ARE NBFCs DIFFERENT FROM BANKS?

  • NBFC cannot accept demand deposits like regular banks
  • NBFCs as per the regulations do not form part of the payment and settlement system and cannot issue cheques drawn on itself
  • Deposit insurance facility of Deposit Insurance and Credit Guarantee Corporation is unavailable to depositors of NBFCs, unlike in case of banks
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Source: Supervisory returns, RBI

WHY NBFC ARE AT GREATER RISK OF DEFAULT?

  • Growing leverage

The NBFCs borrow mainly through debentures and commercial papers (CPs). As per the latest RBI data, the borrowing through commercial paper, which was about Rs 46,200 crore in March 2014 went on to Rs 1,26,700 crore in March 2017. The share of debentures and CP together accounts for over 40 percent in the capital mix of the NBFCs. Both these sources pose a potential risk and high costs.

  • High-interest rate cycle   

The interest rate is rising in domestic as well as global economy. Especially due to a weak rupee and inflationary pressure the RBI might exercise its policy to further push the interest rates. The NBFCs extensively use commercial papers, hence the interest burden is likely to reduce their liquidity position. Moreover, in the long run, debt accumulation skews the balance sheet towards the liability side, making the company a risky business.

  • The rise of small consumer durable loans

The retail loans, especially consumer durable financing, credit cards, and affordable housing segments have expanded their market share in the past couple of years. The unsecured loan segment is also cropping up in the NBFC segment. NBFCs are going aggressively while accumulating assets, narrowing their liquidity. These companies can potentially face a big blow if its borrowers default, setting out a chain effect that will have far-reaching consequences.

Industry officials and experts say they expect Indian regulators to cancel the licenses of as many as 1,500 smaller non-banking finance companies because they don’t have adequate capital. The companies with heavier, richer parent companies are more likely to surpass the storm, owing to their deep pockets, but the new entrants are likely to get swayed along.

IL&FS LIQUIDITY CRUNCH

IL&FS was ex-Citibanker Parthasarathy’s venture into NBFCs, which currently is in shackles of debts. Defaulted in a total of 10 debts, this potentially can be India’s own version of Lehman, fortunately, a lot smaller. What makes this issue even more severe is the domino effect it can have, as the other subsidiaries of IL&FS are also heavy with the debt of  Rs 91,000 crore, yes you read that right.

The spokesperson on Thursday said that IL&FS has defaulted on seven fresh payment obligations worth ₹395.46 crore. Surprisingly, the credit rating agencies were perhaps waiting for IL&FS to announce it’s dwindling balance sheet to the whole world, before working out the numbers themselves, beforehand.

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Source: IL&FS’s Annual Report

WHO ARE LIKELY TO BE AFFECTED IF IL&FS MELTS?

State-owned LIC is the largest shareholder with a fourth of the firm’s equity, while Orix Corporation of Japan owns 23.5%. The third stakeholder is ADIA, Abu Dhabi Investment Authority.  IL&FS is likely to urge ADIA and Orix to raise funds by rights issue, which might consider the offer. The duo is considering to acquire 75% stake in IL&FS, however much remains to be confirmed by the authorities. On the contrary, the market is ripe with stories of ADIA wanting to pull out of IL&FS before it’s too late.

With IL&FS signaling towards harder times, it would be interesting to see how its stakeholders react. LIC stays optimistic, says “IL&FS will not be allowed to collapse”. ADIA spokesperson chooses to stay quiet until the complete picture unfolds.

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AGM TO TAKE THE HELM

Amidst the falling share prices and credit rating, IL&FS called for a meeting of shareholders yesterday to decide the future course of action and to pacify the worried lot. The company proposed to raise funds from shareholders and offload assets to reach solvency after series of defaults.  Their “twin” plan of action consists of:

  • Complete rights issue and recapitalize the company. It plans to raise INR 4500 crores
  • The second part is to sell assets accumulated  to repay creditors and maintain liquidity

Further, in the meeting three key decisions were made as follows:

  • The board will persist in their application under section 230 to ensure the firm’s moratorium to issue debt and securities to satisfy the investors
  • The board is to prepare a restructuring plan to regain the investor’s confidence
  • IL&FS has appointed Alvarez and Marsal to implement the above-mentioned plan

While all said and discussed, the crux of agenda turns out that currently IL&FS is facing debt burden and a timely bailout is required to save the conglomerate from having a domino effect.

DEEP SLUMBER OF CREDIT RATING COMPANIES

The nation’s credit rating industry has come under suspicion after the firms that assessed IL&FS, including the local partners of Moody’s Investors Service and Fitch Ratings, could not see the financial troubles lurking the company’s market standing. The group’s debt burden jumped 44% in the year ended March 31 from 2015, which largely went unnoticed.

It was June when one of the subsidiaries called, IL&FS Transportation Networks Ltd, defaulted on its debt obligations. Subsequent defaults in other parts of the empire followed in August and September. It was only August that the credit rating agencies began to slowly downgrade the conglomerate.

Rating company ICRA, pointed out the group’s “elevated leverage” in March but kept its investment grade rating intact because of “experienced senior management team and its significant track record of operations in the infrastructure domain.”

It’s clear as crystal that given the market situation the following measures must be taken to safeguard NBFCs

  • RBI must reconstruct the provisions regarding sourcing and disbursal of capital by NBFCs. It must tie the loose ends and make the regulations robust.
  • Credit Rating agencies need to evolve their rating parameters and techniques.
  • India needs to do away with the “issuer pays” rule of an audit. This refers to the payment obligation of the company to pay the auditor to rate the agency. This creates a conflict of interest and comes in the way of fair reporting by the agency. Regulatory bodies must step in and handle the rating process end to end.

While the current crisis in NBFCs market coupled with Bank’s NPA pose a challenge to the financial economy of the country, it is an opportunity for the government, the regulators, the stakeholders and people like us to understand the intricacies of basic concepts like leverage, working capital, debt collection period, importance of credit score and most of all, integrity.

REFERENCES

  1. https://economictimes.indiatimes.com/markets/stocks/news/adia-likely-to-skip-ilfs-rights-issue-reduce-stake/articleshow/65988644.cms
  2. https://www.livemint.com/Companies/kDBrz7DB4Ti4Pz2TdxG85N/How-credit-rating-agencies-missed-the-ILFS-crisis.html
  3. https://www.livemint.com/Companies/01mbn5mKGynLct692BCdKN/NBFC-sector-likely-to-face-shakeup-after-ILFS-default.html
  4. https://www.livemint.com/Companies/MxCbOHCMT1seQ8E7ZZ0DqI/ADIA-Orix-Corp-in-talks-to-jointly-bail-out-ILFS.html
  5. https://www.livemint.com/Companies/01mbn5mKGynLct692BCdKN/NBFC-sector-likely-to-face-shakeup-after-ILFS-default.html
  6. https://economictimes.indiatimes.com/markets/stocks/news/adia-likely-to-skip-ilfs-rights-issue-reduce-stake/articleshow/65988644.cms
  7. https://www.livemint.com/Companies/YlDSvn0mgNngEEJPl9EcPJ/ILFS-Financial-Services-declares-fresh-defaults-of-395-cro.html

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