- Non-banking finance companies (NBFCs) are facing a liquidity squeeze.
Highlights of the news
- Defaults by Infrastructure Leasing & Financial Services (IL&FS) beginning September 2018 led to a liquidity squeeze crisis for Non-banking financial institutions.
- The crisis is leading to an offer by State Bank of India to bail out the NBFCs by buying good quality assets from them.
Background of the crisis
- Beginning September 2018, IL&FS, a giant government-owned conglomerate that has executed, or is in the process of executing, some of the largest infrastructure projects in the country, started to default on its commercial papers.
- Since August 27, the IL&FS has defaulted on around Rs 450 crore of inter-corporate deposits to the Small Industries Development Bank of India.
- Following the defaults, rating agencies ICRA, India Ratings, and CARE abruptly downgraded IL&FS and its subsidiary from high investment grade (AA plus and A1 plus) to junk status, indicating actual or imminent default.
- This led to panic in the debt market and a drying up of liquidity in the system— and NBFCs and housing finance companies (HFCs) started to find it tough to carry out their normal businesses.
- This led to a liquidity crisis for NBFCs and last week the State Bank of India has offered to bailout the NBFCs.
About Commercial Papers
- Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note.
- CPs are short-term instruments and the maturity period varies from seven days to up to one year.
- The instrument was introduced in 1990 to enable highly rated corporate borrowers to diversify their sources of short-term borrowings, and also to provide an additional instrument to investors.
- CPs can be issued by corporates, primary dealers, and financial institutions.
- Eligible participants should have a minimum credit rating of A-2 at the time of the issuance of the CP.
- Banking companies, mutual funds, other corporate bodies, NRIs, individuals and foreign institutional investors (FIIs) can subscribe to CPs; they are also traded in the secondary market.
Reason for the crisis
- At the heart of the problem lies the issue of raising funds for long-term infrastructure projects.
- While IL&FS needed funds for 10-15 years for execution of long-gestation projects, it usually raised funds for 8-10 years, and then got the project refinanced.
- However, some three years back, when banks stopped refinancing and funding infrastructure projects, IL&FS was caught in a situation where it needed funds on an immediate basis in order to complete projects that were in various stages of execution.
- It was then that IL&FS started looking at other sources of finance, including CP and debenture issuances.
- This led to IL&FS being caught in a situation of a big asset-liability mismatch, as it was using short-term funding instruments to finance long-term infrastructure projects.
- With a huge requirement of funds but no availability, IL&FS reached a situation in which it could no longer honour its obligations, and started defaulting on commercial papers.
Potential Impact of the crisis
- This crisis spells trouble not only for the firm but also its investors, which include banks, insurance companies and mutual funds.
- Many corporates, mutual funds, and insurance companies have invested in CPs and non-convertible debentures (NCDs) of the IL&FS Group, and there is fear that in the wake of the default, their funds could be locked in IL&FS debt instruments.
- IL&FS’s defaults can have a significant impact on India’s credit markets.
- The firm’s outstanding debentures and commercial papers accounted for 1% and 2%, respectively, of India’s domestic corporate debt market as of March 31, according to Moody’s Investor Services.
- On the other hand, its borrowings from banks – around Rs 57,000 crore – made up between 0.5% and 0.7% of banking system loans.
- Defaults will spell more trouble for Indian lenders, already battling a huge toxic loan pile.
- With the liquidity shortage close to Rs 1 lakh crore in the system, fears have intensified that the funding cost for NBFCs will zoom, and result in a sharp deterioration of their margins.
- Default by a big corporation like IL&FS is likely to keep away potential investors in debt instruments of HFCs and NBFCs.
- IL&FS sits atop a web of 169 subsidiaries, associates, and joint-venture companies that makes the default even more worrisome.
- Sharp losses in NBFC stocks have triggered a vicious cycle — losses in leveraged positions are leading to selling in other stocks to cover those losses, which is in turn fuelling further losses in the market.
- The situation is so grim that it is being compared to the 2008 Lehman Brothers crisis that triggered a global financial meltdown.
- Investors and traders have been worried sick over the cascading effects of IL&FS’s defaults.
- Since the defaults have been on commercial papers, it will affect individual investors, too.
- This is because mutual funds invest in them and these CPs are supposed to be relatively secure investments.
- Even the value of unit-linked insurance plans, endowment plans, the National Pension Scheme, etc. will be hit.
- There may also be some indirect effects.
- For instance, several projects, including the Bengaluru Metro construction plans, are likely to be delayed, which will affect individuals, too, besides the firms involved.
- In dire straits, the company has already put its corporate headquarters, worth nearly Rs 1,300 crore, on the block.
- It has also identified nearly 25 projects for sale.
- By selling these assets, it should bring down its debt and reduce the cascading effect.
- Government should ensure long-term funding for infrastructural projects.
- The Infrastructure giants should be careful while selecting their sources of funding, they should keep in mind the asset-liability match.
- IL&FS is an over 30-year-old infrastructure lending giant that claims to have helped develop and finance projects worth $25 billionin Asia’s fastest-growing economy.
- Apart from envisioning and building infrastructure projects, IL&FS is also a “shadow bank.”
- The term is used to refer to the non-bank financial intermediaries that provide services similar to traditional commercial banks.
- Since these are not deposit-taking companies, they are not as stringently regulated.
- IL&FS sits atop a web of 169 subsidiaries, associates, and joint-venture companies.
- State-owned Life Insurance Corporation of India, which owns a 25.34% stake in IL&FS, is its largest shareholder, followed by Japan’s Orix Corporation (23.54%).
- Other key shareholders are the Abu Dhabi Investment Authority (12.56%), Housing Development Finance Corporation (9.02%), Central Bank of India (7.67%), and State Bank of India (6.42%).