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Indian Shadow Banking bust




Indian Shadow Banking bust

Is IL&FS, Lehman Brothers of India? What actually led to the fall of IL&FS and how it can affect the economy

Depreciating rupee, plunging stock market, government bailouts and IL&FS debt crises, these past few days have been really hard for the Indian govt. It wouldn’t be wrong to say that economy is in a dangerous condition. The only plausible argument government has put by now to justify the plummeted rupee is rising oil prices. Country’s current account has taken a hit with oil prices touching $85, highest since November 2014. While this might be one of the reasons, it certainly is not the only one. In my previous article I wrote about major reasons for the fall in rupee and how government can tackle it. In this article I am going to talk about severity of the recent IL&FS crises that led to one of the biggest bailouts of financial industries.

Recent strings of defaults and huge amount of NPAs have shaken the financial industry and prompted an immediate govt intervention. IL&FS is one other name in the list. The company has apparently Rs 93,000 Cr of debt. Beyond the sheer size of debt, mere presence of the company has sparked fears in non bank lenders that have relied heavily on short term bond funding. IL&FS accounts for around 3% of the Indian bond issuance and with credit rating agencies degrading company’s bonds, there is a wave of redemption among investors. Short term funding have been providing the much needed capital in the market after tightened monetary policy by RBI caused by series of defaults in the recent times.  While bankers and financial analysts were quick to derive striking parallels with the debacle of Lehman Brothers, one of the largest banks in United States, during 2008 recession.  Not only it has sparked a wave of turbulence in debt market but also led to significant cash outflow. This could be a huge blow to our economy considering the size of the firm, in case there is a contagion effect.

One must be wondering what IL&FS basically does and how it all happened. The company, apparently, is one of the biggest NBFCs (Non Banking Financial Corporation) in India. These corporations are non bank lenders that provide short term financing to individuals, projects, small and medium businesses. They have grown rapidly in recent times when banks are weighed down by non performing loans, accounting for 40% of all lending over the past year. Although, these non banks come under the purview of SEBI, regulations are still not as strict as that for commercial banks.  Coming to the company’s business and structure, IL&FS (infrastructure leasing and financing service) has 163 subsidiaries which include SPEs and other unlisted holding companies.  It operates a large diversified portfolio of investments in sectors like energy, infrastructure, transportation, financial etc. It aggressively bids for govt tenders and then issues short term money market instruments to raise capital from banks in order to fund these projects. Major portion of the company is owned by state owned entities with LIC, Central Bank of India, State Bank of India having 25%, 7.67%, and 6.42% respectively which in fact helped them lately in securing substantial amount of short term loans despite having low current ratio and already high debt to equity.





IL&FS infrastructure business is the root cause of company’s debacle. Plummeting currency, unstable economic and political conditions have led significant amount of cash outflows by foreign investors. These outflows combined with political risks, revenue over projections, less toll collections, traffic shortfall below expectations and cost overruns led to a halt in company’s cash flows, consequently resulting in defaults.

Figure below shows a lucid representation of how different entities are involved and how ILFS has managed to secure cash

SIDBI: Small Industries Development bank of India
ABS: Asset backed securities
SPV/SPE: Special purpose vehicle/entity

Company made a precarious choice by relying on short term loans to finance long term projects. This could only have worked when there is a continuous supply of short term loans by the banks. It had been fortunate to secure billion of loans with its assets under construction as collateral. However, with RBI tightening the monetary policy and banks continuously trying to minimise NPAs, IL&FS was always exposed to potential risk of not having enough capital to repay existing loans. And that’s what eventually happened. IL&FS defaulted on Rs 1000 Cr of short term loan from SIDBI (small industries development bank of India). It again defaulted on Rs 105 Cr commercial papers followed by a series of defaults on interest payments and CDOs.

Finally, it came under the scanner of multiple regulators including SEBI and it was not long after, when rating agencies degraded the bonds to junk leaving millions of investors shattered. This triggered a nationwide chaos which can be seen by a 10% drop in market with banks like HDFC, Yes Bank, LIC, and SBI among the top losers. IL&FS is now banned from issuing more commercial papers for 6 months.

Before getting bailed out by government, IL&FS had outdated debentures and commercial papers that constitute 1% and 2% respectively of the Indian domestic debt market. It’s not just the banks at the receiving end, major corporate players, institutional and retail investors are going to take a hit if situation worsens. This can dry up the capital markets leading to liquidity crunch and eventually resulting in economy slowdown. While government has promised to repay the investors, there is still a lot of uncertainty on the possible course of action by the new management. It would be interesting to see how government pacify this unprecedented wave of harrowing events at the time of approaching elections.

Till then I would suggest staying away from the market for a while as it is still very volatile and wait for the right time to take positions in overly sold stocks.


Author: Mohit Tuteja | MS Finance, University at Buffalo, State University of New York | Master of Management, University of Sydney | CFA Level 1 candidate



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