IL&FS crisis: Why it should not become India’s Lehman moment

Madhuchanda DeyMoneycontrol Research

IL&FS was ex-Citibanker Parthasarathy's brainchild and he has now left a sick kid that no one wants to own up to. It wouldn’t have been such a bad thing but for the fact that the illness could lead to a contagion in the financial system that the country can ill afford at this stage.

Central Bank of India, Housing Development Finance Corporation and Unit Trust of India (UTI) were the initial stakeholders of the company. Later the likes of SBI, LIC, ORIX Corporation Japan, and Abu Dhabi Investment Authority (ADIA) bought a share of the pie in the 1990s. It was designated as a systemically-important, non-banking finance company by the RBI.

Being a ‘professionally managed’ unlisted company, it has so far functioned as private sector companies with similar perks and privileges. Hence, it is not a government owned entity that got to be salvaged by the sovereign, in fact, should that happen the risk of moral hazard is high.

Given that the liquidity crisis of this infrastructure lender and its steady default on short-term borrowings have sent shockwaves in the money market and could worsen if the temporary liquidity support is not provided quickly, the owners need to act fast.

The fact that IL&FS' many subsidiaries also owes huge sums to banks and institutions only makes the contagion serious as the total quantum of leverage is in excess of Rs 91,000 crore.

One could blame regulators and stakeholders for not dousing the fire early. It is strange that IL&FS’ AAA rated paper got downgraded to default grade hastily this month once the problem surfaced. Needless to say the sanctity of the rating process is under a question mark and investors are forming their own opinions, resulting in hammering of all papers where corporate governance concerns had surfaced in the past. This is a serious issue for the system and needs to be addressed urgently.

The sanctity of the audit process has been questioned time and again in recent times and IL&Fs is no exception with auditors failing to highlight a strain on the cash flow. Lastly, the board cannot absolve itself as well since a problem of this magnitude never develops overnight.

The challenges in the infrastructure space are common knowledge. A large part of today’s banking crisis can be attributed to banks’ exposure to the sector without much understanding of the complexity. Institutions that were once created to support long-term infrastructure lending have all morphed into commercial banks, realising the unviability of a specialised infrastructure finance company. That IL&FS has an unsustainable business model today need not be exaggerated.

So isn’t it a contradiction to suggest that the existing shareholders pump in emergency liquidity and hike their stake in an entity which is fundamentally unviable. Perhaps it is, but in times like this, in the interest of the financial sector, the owners got to act responsibly. At the end of the day they are marquee names like LIC (25.3 percent), HDFC (9 percent), Orix (23.5 percent), ADIA (12.6 percent) and SBI (6.4 percent). They simply cannot wash their hands off and look up to external parties to salvage the behemoth whose bankruptcy can cost the system dear. Financial markets run on sentiment and confidence and that needs to be restored at the earliest.

IL&FS requires a lifeline to contain the contagion and the owners have to arrange that. However, they also need to decide on the future of this entity, sell assets, restructure the business and transform it into a new entity like others DFIs (development financial institutions) have done. While it is a painful journey and prima facie looks like an impossible task, there are few choices. After all, the owners of IL&FS are also answerable to their stakeholders and they can’t afford to throw good money after bad.

The fact that a savvy investor like Piramal walked away from the IL&FS deal in 2015 is a rude reminder of the faulty business model and it is time the problem is remedied.