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The Harsh Truth About IL&FS

IL&FS should shut down, with only counterparties taking losses, not taxpayers. Alas, this is not going to happen.

Demystifying NBFCs

Non-Banking Financial Companies (NBFC) are a class of financial institutions that are similar to banks in many respects. Like banks, they give loans and take deposits. In most cases, they are licensed and regulated by the RBI. The difference between them and banks is that unlike banks, NBFCs cannot open savings or current accounts, and do not participate in payment systems like NEFT or RTGS or UPI. Because of these small differences, NBFCs are subject to a different set of regulations as compared to banks. In general, NBFCs are subject to a less strict regulatory regime than banks, giving them more operational flexibility as compared to banks. The RBI also has been more open to licensing NBFCs than banks.

This is reflected in the fact that while we have around 150 (scheduled) commercial banks in the country we have more than 10,000 NBFCs. While most of these would be defunct or subscale, as of September this year there were almost 250 non-deposit taking but systematically important NBFCs, and over 100, deposit-taking NBFCs operating in the country. This excludes around a 100 or so housing finance companies, which though NBFCs are not regulated by the RBI but by the National Housing Bank. So we have around 450 reasonably large sized NBFCs in the country, almost 3 times the number of commercial banks.

NBFCs are large and growing fast. In the last few years, loans given by NBFCs have grown at almost 50% faster than the rate at which loans given by banks have grown. In total, loans given by NBFCs are almost 35-40% of the loans given by banks – that’s around US$450 billion of loans as of date.

The point of the above is not to suggest that NBFCs are loosely regulated. The point of this is to suggest that there are limited entry barriers in this segment, which is a good policy. But a corollary of low entry barriers is that there should be low barriers to exit as well. And this is where we come to IL&FS.

Demystifying IL&FS

IL&FS is what the RBI calls ‘Systemically Important Non-Deposit Accepting Core Investment Company.’ That means that it is large, and hence it is systemically important. It does not take deposits from the public, and its principal business is to invest in other companies rather than to give out loans. It is a core investment company.

By now it is well known that IL&FS has defaulted on multiple obligations in the last few months. The government has superseded its board with a set of well-known and well-respected people who now have the unenviable task of running IL&FS for at least the next few months. There is a lot of talk over how the government should deal with this insolvency. But to my mind the solution is simple: if IL&FS cannot get its house in order in a reasonable period of time, then it should be allowed, nay encouraged, to die.

This means that counterparties to IL&FS will take losses. And only the counterparties to IL&FS take losses, not the taxpayers. This is how it should be in any free market – new firms enter a sector and if they are profitable, they grow. If they do not find a way to make profits, they close down, and as a result, people who have contributed capital lose money. There is no reason why this principle should not apply to IL&FS.

While this makes logical sense, our history suggests that this may not happen. A bailout, either directly or indirectly (a ‘forced’ merger of a weak financial institution with a strong financial institution), is inevitable. The bogey that is being raised is that allowing a large financial institution to fail will reduce confidence in the financial sector and threaten financial stability.

There is some merit in this argument. If one of the largest banks in India were to fail overnight, it will erode confidence in the financial system. And trust plays in an important role in the operation of financial institutions in general and banks in particular. But IL&FS, while large, is not among the top 10 to 15 largest financial institutions in the country. And it does not handle public money – it has no retail deposits. Yes, there will be collateral damage if IL&FS inflicts losses on its lenders – some of which is already visible in terms higher credit spreads for borrowings by NBFCs. But that by itself is no reason for a bailout.

It cannot be that companies benefit from running asset-liability mismatch and when that strategy starts to cost them, they cry foul. It cannot be that people enjoy the sunshine as their right, and at the first sign of storm clouds appearing demand that government build a storm shelter.

The Importance of Market Discipline

Apart from being a matter of principle, there is a big reason why a bailout, in general, is a problem. It weakens market discipline. At its core, what market discipline implies is that financial companies are answerable to financial markets from whom they source funds. The financial market is judging financial institutions (as any other company) every day through changes in prices of their bonds and shares. And the standard pushback against this is that financial markets are not perfect. Of course they are not perfect. Neither are they very efficient. But it is my submission that markets wake up to a problem earlier than regulators do. The ongoing NPA crisis in our banks is a good example. The market woke up to the NPA crisis much earlier than either the RBI or the Government or even the banks themselves.

An important element in making market discipline work is for financial market participants to believe that if they make an error of judgement, there is a genuine risk of losing money. And a bailout runs counter to this. If market participants do not lose money for making errors of judgement (but make money when they make right judgements), you create a skewed market – a market that encourages undue risk-taking. And an important way for the market to believe that losses will be imposed is through a precedent to that effect – if the only precedent is that whenever a financial firm gets in trouble it is bailed out and no losses are inflicted on its counterparties, then market will presume that the next time a firm gets in trouble, it will also be bailed out, and bondholders and lenders will not have to take any loss. The market will thus lower its guard of companies, ignoring their risky behaviour.

A bailout today sets a very bad precedent for how people will behave in financial markets tomorrow. So the threshold for a bailout has to be set very high – an actual doomsday scenario – something akin to what happened in the US in 2008, when a number of their top 10 financial institutions were at the risk of going under overnight. We are far away from such a scenario currently.

There are two more important points relating to market discipline that are in a way linked to the current IL&FS. The first is access to timely information. Listed companies are required to publish their financial statements every quarter, and have to also provide a qualitative commentary on your business. In a way, the market judges you every quarter. But IL&FS was an unlisted company, and hence it did not have to publish its financial statements on a quarterly basis.

Recognising this, SEBI has made it mandatory for companies with listed debt securities to disclose half-yearly financials. This is necessary, especially in the case of financial companies where the larger you become, the more risk you add to the system from any missteps that the company might take. However, the current regulations are not good enough. The case of IL&FS itself makes it clear.

As per summary financials disclosed by IL&FS on May 31 pursuant to the SEBI norms, it had a debt of just Rs16,000 crores and it had made a profit of almost Rs600 crores for the year ended March 31, 2018 (50% higher than the preceding year). Not quite a company on the verge of insolvency. But, in reality, the IL&FS group in entirety had a total debt as of March 31, 2018 of 91,000 crores and had made a loss of almost 1900 crores for that year. This full data comes from IL&FS’s annual report which is released towards the end of August. And this year, by that time, the first default had already occurred (in June).

The reason for the difference between the data in Annual Report and the data disclosed as per SEBI’s rules is that SEBI rules do not mandate disclosure of group level financials. And the principal business of IL&FS was to invest money in group companies and it had over a 100 group companies. So, the interim financials that IL&FS used to report every six months was incomplete and not representative of what its true financial position was, making the data not just irrelevant but actually misleading. My submission is that if IL&FS were to be subject to the same disclosure norms that a listed financial company would have been, we may perhaps not have been able to avert the crisis, but at least been able to detect it earlier.

It is time SEBI modifies its rules. Unlisted financial firms above a certain size must be subject to same disclosure standards as their listed counterparts for the sake of market discipline.

The second is about size. Large financial companies are a problem. They are a problem because if they get into trouble, it is almost impossible to not bail them out because of the collateral damage they can inflict on the economy. The market knows this, and hence it lowers its guard when dealing with large financial institutions – the risk of their failure is not a thought anyone is willing to entertain. The only way to deal with this, from a policy perspective, is to have a desire for smaller financial institutions.

But our policy explicitly promotes large financial institutions. Just see our response to the NPA issue that PSU Banks are facing – we are merging several small and weak PSU banks to create one large weak PSU bank. Does that increase the chances that taxpayer money will be used for a bailout in the next crisis as well or reduce this risk? I think it is time for our regulations to explicitly favour smaller financial firms – and the only way to do this would be to significantly ease entry and exit of firms in the financial sector. And firms with different business models. But that is a separate topic in itself.

Regulatory Arbitrage and Distress

Two final issues that arise from the IL&FS crisis, before I close. The first is of regulatory arbitrage between banks and NBFCs. If banks and NBFCs do more or less similar activities, why should they be subject to significantly different regulations? Why should banks be so tightly regulated that they have their own fully-owned NBFCs through which they route a part of their business? There is also a restriction on entry of new banks which is tightly controlled by the RBI. There is a strong case for banks to be less tightly regulated and the regulatory arbitrage between banks and NBFCs be eliminated. The amount of capital that a Rs100 mortgage should attract should not depend on whether the loan is being given by a bank or an NBFC. Neither should the amount of liquidity that needs to be maintained be a function of whether the entity is a bank or NBFC.

The second pertains to the law to deal with distress among financial firms. In the case of non-financial firms, the Insolvency and Bankruptcy Code provides a legal framework to resolve distress. There is no such law in the case of financial firms. But we could have had one. The Financial Resolution and Deposit Insurance (FRDI) Bill that the government wanted to pass early this year provided for a legal framework for dealing with distressed financial firms, as well as a mechanism to protect depositors through a revamped deposit insurance scheme. However, politics did not allow that bill to be passed.

If that bill had been passed, we would have had a proper legal framework to deal with IL&FS. Fortunately, IL&FS does not have public deposits which would have complicated matters. But we need the FRDI bill or its equivalent to deal with distress among financial sector companies.

Also check out:

The Rot That IL&FS Reveals: Episode 91 of The Seen and the Unseen

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About the author

Ashutosh Datar

Ashutosh Datar was the Economist at Institutional Equities research team of IIFL from 2007 till a few months ago. He is now an independent blogger.