The IL&FS crisis highlights regulatory failure in the financial sector

IL&FS should not have been allowed to get to this stage

The ongoing crisis in Infrastructure Leasing & Financial Services (IL&FS) has cast a shadow on the entire financial sector. The complex structure of the lending that passed through IL&FS, as well as its structural characteristics, is partly responsible. IL&FS lent to many long-gestation projects through various subsidiaries. It partly funded this through high-rated debt. The problem is that sometimes a maturity mismatch can develop — long-term returns are funded by short-term debt. Naturally, this can be unstable and is susceptible to business-cycle downturns. Given the solid credit rating of IL&FS paper, it has been extensively and widely bought by various capital market funds. That rating has now been downgraded to junk status. Thus, a collapse in IL&FS — or a trip through the bankruptcy process — carries with it the risk of contagion spreading across the financial markets. Moody’s has estimated that IL&FS’s bank loan exposure is 0.5-0.7 per cent of banking system loans, while its outstanding debentures and commercial paper accounted for 1 per cent and 2 per cent, respectively, of the domestic corporate debt market. Funds compensating for losses on IL&FS could sell other instruments, propagating panic through the markets. The opacity of such inter-connections means that there is considerable uncertainty about the size and distribution of risk — which are the conditions under which lending could seize up.

Naturally, the priority must be in ensuring that the shareholders of IL&FS infuse sufficient funds, to the extent that short-term liquidity, as opposed to long-term insolvency, is the problem. They bear considerable responsibility for the situation: After all, the risk management committee of the troubled institution reportedly met just once in the past three years. Yet, broader lessons about the Indian financial sector must also be learned. One is that the central question of how infrastructure is to be financed remains unanswered. The government does not have the resources. Long-term bank lending has dried up following new regulatory mechanisms. “Shadow” non-bank financial service providers such as IL&FS clearly also have their own problems. It is unfortunate that newer structures such as the National Infrastructure Investment Fund have been slow off the mark. It may also be time to revisit the notion of development finance institutions, and see whether they are capable of being part of the solution to the problem of funding infrastructure.

It is also clear that IL&FS should not have got to the stage where it poses a systemic risk — the Reserve Bank of India should have stepped in much earlier. There is also a regulatory body that exists precisely to manage such systemic risk, and organisations which have operations in multiple verticals such as IL&FS. That is the Financial Stability and Development Council, or FSDC. This was designed to be the apex regulator of the entire financial sector. It has failed to meet that requirement, and has turned instead into a rubber-stamp for other regulators. For example, the purchase by India’s largest insurer of a failing bank, a fit subject for the FSDC, was barely discussed. This is not good enough. The government recently expanded the membership of the Council. But what is needed is a larger number of full-time members, independent capacity, and ideally an independent head rather than the finance minister. The costs to the Indian economy of poor regulation and co-ordination are once again becoming apparent.