Prelims cum Mains

What is the market instrument at core of IL&FS woes?

The News

  • 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.

 

Way forward

  • 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.

 

About IL&FS

  • 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%).

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