IL&FS defaults can lead to systemic risks in financial sector, says DEA

The Department of Economic Affairs (DEA) has come down hard on the state of affairs at Infrastructure Leasing & Financial Services (IL&FS) in its petition to the National Company Law Tribunal. It has said that defaults by the group can lead to systemic risks in the financial sector. 

“There is a substantial public interest in ensuring financial solvency and good governance and management of this Group. The cascading impact of the default by the IL&FS Group on the financial sector would be quite substantial as evidenced from a partial default of some companies.” 

The main is the group’s dwindling finances. In 2017-18 the group showed a loan loss of Rs 26.7 billion while its total borrowings stood at Rs 910 billion on the base of equity capital and reserves of about Rs 69.5 billion. And as on September 29, 2018, the group’s subsidiary companies like IL&FS Financial Services had defaulted on Rs 37.6 billion worth of payments. By October 2018, another Rs 10.66 billion of IL&FS bonds will be due for repayment.

As many institutions including banks, non-banking financial companies (NBFCs), asset management companies (AMCs), the Life Insurance Corporation (LIC) as well as foreign investors have significant exposures to the company’s debt instruments, these defaults could hurt the entire financial sector, and in some ways, hit government spending as well.  

The DEA has said that AMCs have an exposure of Rs 28 billion in IL&FS bonds. And these funds could see a redemption pressure from corporate clients who invested over Rs 16 trillion in debt funds. And during a period where the corporate debt market is facing liquidity constraints, the recent pressure in some NBFC stocks may force AMCs to sell government securities. “Therefore, this would lead to selling pressure on government securities prompting the bond yield to rise to 8.30-8.50 per cent levels or the Reserve Bank of India (RBI) has to do OMO (Open Market Operations). If RBI Opts for OMO, then the Government’s spending capacity will reduce by an equal amount,” the DEA states.

NBFC stocks like Indiabulls Housing Finance, Dewan Housing Finance and Bajaj Finance, to name a few, have been facing pressure due to market and analyst concerns surrounding their liquidity positions and reliance on the corporate debt market for raising funds. 

According to the petition, mutual funds who are active buyers of corporate bonds have stopped buying completely, and corporate bond yields have risen further by about 40-50 basis points post the IL&FS crisis.

There are also fears that as many as 1,500 NBFCs might lose their licences because they do not have adequate capital. And liquidity crunch and recent events will lead to the cost of funds for NBFCs increasing, impacting profitability 

In addition, the exposure of banks to the IL&FS group is pegged at Rs 530 billion, then the entire banking system’s total exposure to all NBFCs would be pegged at around Rs 3.3 trillion. “Therefore, there is a substantial public interest in ensuring financial solvency and good governance and management of this Group,” the MCA recorded in its plea before the NCLT. 

Further, it states that the ineffective functioning of the risk management committee of the board, considering the business model to borrow short-term for long-term projects, displays a critical lapse in the functioning of the company’s management and the board’s governance. 

On Monday, the NCLT accepted the plea by the Ministry of Corporate Affairs under Section 241 of the Companies Act. As a result, the tribunal suspended the board of IL&FS and reconstituted the board with six members, based on nominations made by the government.

Pain points for stakeholders and the financial sector

• As on September 29, the group had defaulted on Rs 37.6 bn of payments
• By October 2018, another Rs 10.66 bn bonds will be up for repayments
• AMCs may be forced to sell government securities to meet redemption pressures
• Since the crisis, bond yields have risen by 40-50 bps
• If RBI is forced to do OMOs, the capacity of government spending will be reduced by an equal amount
• Around 1,500 NBFCs could lose their licences due to inadequate capital