The IL&FS crisis which occurred in 2018, triggered several effects on the Indian economy such as a lack of infrastructure funds and a sharp downgrading in credit assessment. In this post, we analyze the several dynamics that led to the collapse of the Infrastructure Leasing and Financial Services (IL&FS) and its consequent repercussions on the Indian economy.
| IL&FS was called a ‘shadow bank’ – a term used to refer to intermediaries in the banking and finance segment that provide similar services as that of traditional banks, however, they are not under similar regulation. |
What is IL&FS?
IL&FS stands for Infrastructure Leasing and Financial Services Ltd., which was also the holding company of the larger group known as the IL&FS Group, which dealt in investments as its core business. IL&FS was founded in 1987 with its major equity being held by the Central Bank of India, Unit Trust of India, and Housing Development Finance Co to fund infrastructure projects since most contemporary banks of the time were focused on corporate funds rather than infrastructure-based funds. I
L&FS’s major shareholders included Life Insurance Corp of India holding a 25.3% stake, State Bank of India with 6.42%, Japan’s Orix Corp holding 23%, and the Abu Dhabi Investment Authority with 12%.
It was registered with the Reserve Bank of India as a ‘Systemically Important Non-Deposit Accepting Core Investment Company, with over ₹1,15,000 crore of assets and ₹91,000 crores of debt, and looked very promising, to begin with.
Antecedents That Led to the Failure of IL&FS
The following factors can be attributed to the massive financial crisis in which IL&FS found itself. While some of these are purely economic reasons beyond the enterprise’s control, a majority of these factors were the direct result of manipulation, evasion, and financial imprudence. Let’s take a look at some of them:
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Too Much Debt in the Company
This was the single most important factor that led to the fall of the company. With a consolidated debt of around ₹90,000 crores, the company was simply unable to find resources to pay off its debt and found itself in an asset-liability mismatch, which refers to a situation where there is a lot of liability on the entity in the form of loans (both short term and long term), creditors, commercial papers (an unsecured form of short term money-raising instrument from the market) as compared to fewer assets, in the form of receivables, cash or inward-investments.
It is said that the IL&IF crisis came to light in August 2018 when the company found itself unable to service a debt of ₹1000 crore owed to SIDBI – the Small Industries Development Bank of India. This debt failure led to an investigation that unearthed many more reasons for the default of the company.
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Mounting Losses in the Infrastructure Sector
Financial analysts believe that the longer the project’s gestation period (the time it takes from the planning stage to final execution), the greater the risk. This proverbial prediction comes true in the case of IL&FS’s investments. Historically, the company has begun investing in power, road, and water projects with gestation periods ranging from 8 to 15 years. The company would then re-finance the project, obtaining additional debt, but in recent years, with the NPA crisis plaguing most major banks, IL&FS was forced to seek alternative sources of funding, such as short-term loans from the market, which it was unable to repay.
Road building, power, and waterworks projects accounted for more than 60% of the company’s debt. Not surprisingly such projects have frequently been found to be plagued by a variety of issues, including land acquisition complications, ongoing disputes between contractors and the government that result in litigation and arbitration proceedings, long project delays, massive escalation costs, labor, and raw material shortages, and so on.
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Manipulation in Credit Ratings
The fact that despite impending financial challenges and irregularities in the company’s financial statements, most credit rating agencies gave the company a AAA rating is a huge surprise.
Forensic audit investigations have revealed that email exchanges between credit rating agencies (such as Crisil and Care) revealed the company’s poor financial health, but final certifications revealed no downgrade. The company’s true rating was only revealed in 2018.
Tracing the IL&FS Crisis and its Impact on the Indian Economy
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On Individual Investors
Since IL&FS had begun raising huge amounts of money from the market by way of commercial paper, which is an unsecured debt meant for immediate financing needs, the worst affected were investors that include mutual funds, individuals, banks and other companies, which offered a loan by way of inter-corporate deposits.
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On Infrastructure Projects
The IL&FS crisis is likely to have a major effect on current infrastructure projects. For example, in Maharashtra, government officials believe that the refusal of banks to offer loans for continuing work on the highway for the Mumbai-Nagpur Communication Expressway is a direct result of the IL&FS crisis.
The crisis made banks extremely wary of releasing funds for road projects. Moreover, IL&FS’ existing projects also faced a critical blow, some of which were in the form of a PPP model (Public-Private Partnership) for developing national highways and connecting roads.
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On Credit Rating Agencies
The crisis highlighted the lack of transparency, accountability, and subversion of credit rating agencies, which were supposed to exercise principles of prudence, caution, and utmost integrity. The government has tightened its grip on credit rating agencies and imposed harsher penalties for fraud after the crisis.
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On the NPA Crisis and the Spillover on the Economy
Following the crisis in 2018, a severe funding drought triggered a liquidity crisis for NBFCs. After the crisis, NBFCs had a difficult time, owing largely to the failure of Infrastructure Leasing and Financial Services (IL&FS). In fact, investors withdrew large sums of money from major NBFCs, particularly housing finance companies. As a result, the RBI announced measures in its February 2019 policy to ensure flexible credit facilities for well-rated NBFCs. This was done on the back of RBI tightening NBFC credit norms and bank exposure for lending made dependent on ratings.
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