Even as the IL&FS fire continues to take a toll of the players, auditors and rating agencies being the latest, the problems that created the liquidity crisis seem to have receded into the background, with all attention on the mis-governance unravelling by the day.

A question from a former Chief Economic Advisor as to why the RBI’s Financial Stability Report (FSR) could not spot the IL&FS crisis is a good starting point to understand why regulatory oversight failed. The FSR, ever since it was published, focussed largely on risk from the banking system, simply because banks account for over 70 per cent of the financial system and had high inter-linkages.

Besides, the NBFCs sported better financials — lower NPAs, higher capital adequacy and higher profitability. The IL&FS default may then well have been an exception, but equally, it could also have been an unintended consequence of the mis-labeling of IL&FS.

Perhaps, the RBI went by technicalities such as the proportion of financial assets or interest income in classifying IL&FS as an NBFC, but it becomes important because it sets out the regulations under which IL&FS would be governed. In hindsight, this proved inadequate.

Consider these facts: the IL&FS group was an amalgam of nearly 300 entities of which only two (IL&FS and IL&FS Financial Services — IFIN) were classified as NBFCs under RBI supervision. These two entities held over 35 per cent of the group debt, including the short-term paper that went into default.

The intra group transactions may now seem complex but were apparently de rigueur in infrastructure financing. The group’s business was itself unique — it was both a financier and developer of infrastructure projects, suggesting further that the NBFC moniker was inappropriate.

While IL&FS mostly made equity investments in its subsidiaries, IFIN gave out loans but also invested in equity; but the subsidiaries, engaged in different infrastructure sectors such as roads, water supply, transportation and the like, had varied operating models — BOT contracts on PPP basis, direct contracting under EPC mode — so much so their asset profiles were a motley mix of fixed assets, intangibles, receivables and loans.

The intangibles actually represented the book value of the company’s rights under their service contract agreements from ongoing projects and in one case, were as high as 60 per cent of assets (ITNL). The point is that an asset profile such as this does not make for a definitive or contractual cash flow generation model; it is a surprise they were at all able to manage cash flows to repay debt obligations.

Perhaps the long-term nature of their debt (over 70 per cent, with over 40 per cent NCDs having tenors exceeding 10 years) helped. But it was their short-term debt, a small portion, that was the source of troubles. NBFCs are required to submit ALM statements to the RBI detailing their estimated outflows and inflows under granular time buckets.

Though the mismatch levels probably passed the RBI norms, the fact that both IL&FS and IFIN had nearly 15 per cent of their liabilities flowing out in under 90 days should have been a red flag, considering their overall debt was essentially long dated and their cash inflows were not contractual given the nature of their assets. This sets up a classic funding liquidity risk that is not always visible in cash flow statements. It turns out the two NBFCs relied on investment income, monetization of assets and divestments rather than regular cash flows as would have been the case for a normal NBFC in the lending business. The recourse to short term borrowing was perhaps to fill deficits in cash flow caused by monetized flows not materializing, but it perpetuated the funding liquidity risk, because the default probabilities now become predicated on the ability to refinance debt and not so much on cash flows.

The fall out of the ILFS default was that it impacted the ability of other NBFCs to refinance their debt. To be sure, financial misdeeds and frauds dented their credibility, but primarily the problem was a funding liquidity issue rather than market liquidity. By switching from banks to MFs, many NBFCs had already exposed themselves to funding liquidity risk and the ILFS default vitiated the market. This was because MF subscribers, unlike bank depositors, were finicky investors prone to exiting at the sign of trouble. But since the RBI believes that market liquidity was adequate on an average, the reluctance of banks and MFs to lend only signals a deficit in confidence rather than funds; which also means that mere liquidity enhancement measures may not be enough.

The writer is an independent financial consultant

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