Breaking Views: IL&FS Crisis Throws Light on ‘Regulatory Darkness’

The financial sector in India is going through its biggest crisis after Independence.

(Photo: The Quint)

IL&FS, an infrastructure project finance company has defaulted. This has created panic in the entire financial market. The Infrastructure Leasing & Financial Services (IL&FS) is a 30-year-old financial firm that would provide loans for infrastructural projects. This situation is the biggest distress in the post-Independence Indian financial market.

Markets in a Slump

Ever since the news of the IL&FS default was made public, Sensex & Nifty went on a five-day downward spree. There was chaos in the bond market as people thought if a company with such a huge debt is about to default then what does it say about the condition of liquidity in the market?

Warning signs about IL&FS could be seen as early as 2008. In June 2018, when the founder, CEO and Chairman of IL&FS Ravi Parthsarthy stepped down (or was removed), the warnings became clearer but the problem was that no one knew that who is the regulator of this crisis?

Till now, the Reserve Bank of India, the Finance Ministry and the Securities and Exchange Board of India had steered clear of the issue, but a continuous slump in the share market for five consecutive days forced the authorities to take action. The Sensex fell by 1,800 points in five days. Share market investors lost almost Rs 7 lakh crore.

It was then that the government stepped in on Sunday, 23 September, to ensure that the markets don’t collapse further on Monday. For the first time, SEBI and RBI issued a joint statement which basically said that all is well in the market.

Despite the assurance, the market collapsed further on Monday. Nifty went down by 150 points. Looking at the situation, a mutual fund company decided to sell off their commercial papers assuming that the bond market is also facing lack of liquidity.

The difference between supply and demand is close to Rs 1 lakh crore. This further fuelled the crisis in mutual funds and NBFCs and despite multiple steps taken by the government, the market didn’t stabilise.

IL&FS Crisis: Story of ‘Regulatory Darkness’

The IL&FS crisis is the story of “regulatory darkness” in India. This is so because the government created a good draft of new reforms through Bankruptcy Bill but the FRDI Bill was put in cold storage. This meant, while the non-financial firms could be regulated under the new IBC (Insolvency & Bankruptcy) Bill, a regulatory authority to manage large scale financial firms was missing. This problem has now been exposed.

A cover-up will be attempted. They will try to stabilise the market. IL&FS may be bought by the Japanese firm Orix, which is the majority shareholder. But this is not a solution. You may argue that Orix buying IL&FS will create a perception among mutual funds and NBFCs that liquidity is back in the market, flow of cash has resumed and the money can be lent or borrowed. However, this seems highly unlikely. This is not how you manage a crisis in the financial sector.

India was able to mitigate the fallout during the Lehman Brothers crisis because both the the Finance Ministry and RBI were vigilant. In today’s scenario, RBI became vigilant after a considerable amount of time had passed.

But one must look into the situation of the RBI. They hold some leverage over private sector banks. They even forced them to change their CEOs but that is not the case with public sector banks. Those are controlled by the Finance Ministry. So, even if the RBI has regained some of its credibility, a question will be asked that if regulation was a grey area in which the RBI had no role to play, how are they actively involved in it now?

The Reserve Bank has called a meeting on 28 September. The agenda will be how to manage this crisis in future.

But what about the steps that were needed to be taken in the past?

5 Villains in IL&FS Crisis

The IL&FS crisis can be linked back to five institutes.

1. Rating Agencies – The rating agencies rated IL&FS as an AAA company and encouraged investors to invest their money in it. But now, they have conveniently rated it as junk.
2. Board of Directors – All the senior office-holders have resigned from their posts.
3. Shareholders – The major shareholders of IL&FS: SBI, Orix and LIC also failed to monitor the company that they invested in.
4. RBI – If the RBI is considering itself a regulator today, it could have done the same when the crisis started. It could have registered early warning signals.
5. Government of India – The government never considered a systemic solution if the financial sector ever found itself in trouble. It never assigned a regulator.

This is what I mean when I say that this is a story of “regulatory darkness.” As of now, the role of regulator has to be played by either the RBI or the Finance Ministry. Both of them ignored the problem.

Today, this has created a panic among major mutual funds & NBFC players. They want to sell off their bonds despite an increase in cost of funding.

What Are the Options?

Even though the concerned authorities missed the warning bells in last 10 years and especially in last six months, it’s important for them to now control the panic reaction and instead of taking harsh measures try saving the asset and hand it over to a reliable firm.