What began as a one-off financial crisis at one of the big names in the non-banking finance space — IL&FS Financial Services failing to repay its commercial paper dues — is now threatening to blow into a possible liquidity crisis rippling through the entire NBFC universe.

When the ratings of project financier IL&FS and its subsidiary IL&FS Financial Services were sharply downgraded, little was it known that the contagion effect of the episode would be so far-reaching, that it could trigger massive selling of NBFC stocks. Are the doomsters right in viewing this event as our very own Lehman crisis that could topple markets and shake investor confidence?

Only time will tell. For now, it is evident that the Centre and the regulator can no longer drag their feet in the matter and need to ensure adequate liquidity to hard-hit mutual funds and NBFCs. More importantly, the entire episode has once again raised concerns on the manner in which auditors carry on their affairs. How did the weak financials of IL&FS not raise alarm bells for investors, lenders, rating agencies, regulator and auditors?

Heady growth in loans and alluring profitability metrics of NBFCs have drawn investors in throngs over the past few years. While huge pockets of growth opportunities, niche offerings and dominance in certain geographical areas are inherent strengths for NBFC players, the manner in which some have aggressively grown their loan book in risky segments, relying extensively on short-term debt, has been a concern.

Hence the answer to the mindless carnage of NBFC stocks over the past few days to a lot extent, lies in the way some NBFCs have grown their loan book aggressively, aided by boundless appetite for their debt papers and easy access to bank borrowings.

A liquidity crunch and recent events hitting market sentiment will lead to cost of funds for NBFCs increasing, impacting profitability. To ensure that the entire episode does not lead to a credit freeze, the RBI and the Centre, rather than offering weak assurances, must take some concrete measures to ensure adequate liquidity in the system.

They also need to turn their focus on some grave fundamental issues that the entire saga has brought to the fore. How did the risks building up in the books of NBFCs, in particular that of IL&FS not raise red-flags?

Serious lapses

This brings us to the IL&FS episode where the mayhem began in the first place. A look at the financials of ILFS Financial Services (IFIN) — whose commercial paper was swiftly downgraded from A1+ (having a very strong degree of safety and lowest risk) to A4 (very high credit risk to default) and then to default status in a matter of two weeks — suggests that there were enough warning bells in the company’s books for lenders or ratings agencies. As per the FY18 financial results of the company, its gearing (debt/equity) was a high 8 times and the rise in provisioning and interest costs was already adding pressure on the company’s profitability. The company’s exposure to infrastructure sector, only increases the risk. While rating agencies have been taking note of the company’s high concentration in loan book, deterioration in asset quality and subdued profitability, they assigned top notch rating to the company’s CPs, drawing comfort from the strong parentage of the IL&FS group.

But the swift downgrading of the parent company’s ratings has once again highlighted that placing undue importance on promoter backing and parentage can cost dearly— ratings of instruments issued by many PSU banks suffer from a similar myopic view. In ICRA’s September 3 release, the rating agency had taken stock of a delay by IFIN in meeting its commercial paper (CP) repayments due on August 28, 2018.

But since the delay in CP redemption was on account of technical issues and the facilities were repaid through surplus available with IFIN along with funding support from the group, the rating was left unchanged.

In its September 17 release when it finally downgraded the company’s CPs to D rating, citing recent irregularities in debt servicing, it also interestingly mentioned the change in definition of ‘companies in the same group’.

It has stated that as per IFIN’s board policy, each business vertical of IL&FS and its respective SPVs were considered as an individual group; thus the various verticals were not treated as companies of the same group.

The company, however, has been directed by the RBI now to follow guidelines set out in the Companies Act, for determining ‘companies in the same group’, wherein entire loans to IL&FS group companies would be classified as exposures to companies in the same group, impacting capital adequacy calculations.

Such reporting lapses coming to fore only after a crisis unfolds once again raises questions over the murky role of auditors in the entire episode, much like in the PNB scam.

For the IL&FS group as a whole that has a consolidated debt of about ₹91,000 crore, the high debt level itself should have raised red-flags with lenders and the regulator. Given that the group has about 135 subsidiaries — 27 direct and 105 indirect — and loans have been extended to group companies, the regulator, as a pre-emptive measure, should have ensured proper inspection of the books of accounts.

Digging deeper

Road construction is undertaken by IL&FS mainly through special purpose vehicles floated by its subsidiary IL&FS Transportation Networks (ITNL). There have been claims made by IL&FS that if the money released by the concession authorities were released on time then the entire mess would have been avoided.

While there may be other reasons for the trouble at IL&FS, the Centre on its part should look at long-term solutions for pending clearances and payments by central agencies for infrastructure projects.

Above all, given how systemically important IL&FS is, and its multiple layers of subsidiaries, a forensic probe into the affairs of the company is essential to ensure that the episode does not lead to even bigger financial contagion.

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