The IL&FS default crisis has been described as, among other things, a shadow-banking problem and as India’s own Lehmann moment. But we also need to look at some key issues it has brought out — the failure to find a sustainable solution to funding infrastructure and manage systemic risk in a highly interconnected financial system.

IL&FS’s problems are primarily the travails of infrastructure financing and not that of a rogue non-banking finance company, even though the NBFC structure, in hindsight, seems inappropriate for its style of business. The problems are well-known — lack of long-term resources and long delays in realising cash flows — both of which force firms to borrow short term.

However, to its credit, IL&FS managed to have an optimal borrowing mix (over 75 per cent long- and about 25 per cent short-term) and also a reasonable debt-equity ratio for an infrastructure company. Yet, it defaulted on its short-term obligations. The problem seems to be with its business model — revenues dependent on dividends from investments and rapid monetisation of projects, than on an assured tariff stream. There were other differences — SPV (special purpose vehicle) structure and multiple PPP (public-private partnerships) models, especially in its roads arm (the principal contributor to the group) — which set it apart from conventional bank lending.

Although banks also have burnt their fingers (NPAs of over ₹1 lakh crore), that did not create a systemic crisis because they had funded them through deposits which continued to flow in. But non-deposit-taking NBFCs depend on market instruments such as CPs (Commercial Papers), CDs (Certificates of Deposits) and debentures which are driven by credit rating and valuation and whose supply can dry up when defaults occur.

IL&FS’ problems would have been evident to anyone closely tracking their financials over the years — a steady increase in short-term debt, declining revenues, a massive cash loss in 2018 and completion issues with projects, especially roads. Perhaps, the straitjacketed regulations of NBFCs did not prove adequate to flag the risks.

While project-financing majors such as IDBI, ICICI and, later, IDFC saw the writing on the wall early on and transformed into retail banks, IL&FS — possibly due to its unique structure and business model — became an RBI-registered ‘core investment company’ (NBFC) while its financial services arm became a ‘systematically important non-deposit-accepting NBFC.

Just a ‘light touch’

Although called shadow banks, NBFCs operate under the so-called ‘light touch’ regulation of the RBI, which is actually quite elaborate, covering a wide range of regulations from capital adequacy and asset classification to credit-exposure norms. These work well for a conventional NBFC which is bank-like; but for an entity as complex as IL&FS, the criteria probably need to be customised.

For instance, high leverage for the holding parent, by itself, may not indicate trouble, not only because leveraging is the nature of its business, but also because leverage is capped by regulations for core investment companies at levels lower than traditional financing companies. Likewise, when infrastructure projects take longer than expected to be monetised, loans from the parent may turn NPAs, but the measures or recourse available to banks may not be appropriate for these companies (Nearly a fourth of the IL&FS group’s non-current assets consists of intangibles representing the value of rights under service concession agreements).

There are measures for asset-liability management and reporting, but then, even with its moderate gearing and long-dated liabilities, ILF&S defaulted on short-term obligations. With liabilities spread across entities and with non-contractual revenue streams, tracking asset-liability mismatches can be challenging.

Systemic risk

The default also brings out another aspect of the regulation of NBFCs, relating to systemic risk. The RBI’s Financial Stability Report tracks systemic risk, but largely that of the banking sector, which is its biggest constituent. The report also monitors interconnectedness in the financial system — which is high. It carries out a contagion analysis — which is again bank-centric — that estimates the impact of bank failure on system solvency and liquidity.

But NBFCs do not seem to be tracked as closely, in spite of their being the largest net borrowers in the inter-bank market (₹7 trillion), followed by housing finance companies (₹5 trillion), as per the RBI’s June 2018 report. The funding requirements of these two segments were met by mutual funds (₹8 trillion) and insurance companies/financial institutions (₹5 trillion).

This mutual dependence — lending companies depending on hot money (mutual funds) and mutual funds taking short-term bets on lending companies (NBFCs) — is a mismatch that could pose a greater systemic risk than banks themselves.

More so because even while their gross transaction volumes were huge, banks’ net exposure was low as they transact among themselves. As the IL&FS crisis has shown, a default by NBFCs can create a crisis across many markets, which should be a wake-up call for regulators.

The writer is anindependent consultant