IL&FS debt fiasco: Not a Lehman moment for India but a wakeup call for the government

Despite the worries expressed by many market watchers, the troubles at Infrastructure Leasing & Finance Ltd (IL&FS) are unlikely to spill over and create a financial crisis for the country, as the Lehman collapse did for the global financial systems. Yes IL&FS is deep in trouble and, along with its numerous subsidies, has a debt burden of Rs 1 lakh crore and lacks the cash to service. Yes, few people saw it coming - and its lenders could be in major trouble if it defaults on all its liabilities. And sure, it could cause a ripple effect and a panic attack in the debt markets in the short run.

But unlike Lehman, the government has already indicated that IL&FS is not going to be allowed to collapse. The rescue plan is already in place and its shareholders like LIC and SBI are ready to give it enough money to meet its repayment obligations.

However, the IL&FS case should be a wakeup call for the government precisely for the reason that it reached a stage of collapse without anyone spotting the problem early on. Unlike the case of banks, where the Reserve Bank of India (RBI) had spotted the problems early on, and where it had prodded them to recognise the bad debts and clean up balance sheets, the IL&FS case shows the gaps that exist in our financial systems especially asset liability mismatches or the credit risk in the NBFC space even now, which need to be plugged quickly.

Technically, IL&FS is not a government company. It however acts like one, and with big shareholding from LIC, SBI and HDFC, and staffed with plenty of bureaucrats and former bureaucrats, it behaves pretty much like a government company. The fact that it enjoyed the status of a systematically important institution as per the RBI, but this particular regulator does not have full visibility of the entity.

The problem is in the peculiar nature of IL&FS. First, as earlier pointed out, it is supposed to be a private company, which acts like a quasi-government arm because it lends to the infrastructure sector and has a lot of big government companies and banks as shareholders. More importantly, it is both a lending institution as well as an execution company. It has bid, won and taken on projects under various subsidiaries, and which in turn have raised debt financing both from the parent as well as from the market. The subsidiaries were needed to be created because the government regulations mandate that each concession based infrastructure project needs a separate entity because loans are taken specific to that entity and project. With IL&FS taking on so many projects, it became a highly opaque structure with the government as a partner in most of its projects, which gave many the feeling of comfort that the risks were underwritten by the government. And it had a management team, which successfully hid the rising crisis and tried to bury it under the carpet until it could no longer do so. In fact, Ravi Parathasarathy who created it and led it for three decades, resigned suddenly a few months before the defaults by both the parent and its subsidiaries started. The RBI had visibility of its bank loans etc, but did not have enough idea about the rest of its borrowing from insurance companies or the corporate debt it had raised.

The auditors failed to catch the coming troubles at IL&FS and so did the credit rating agencies. How did that happen? One reason perhaps was the shareholding and the projects and the dozens of subsidiaries that made things even more complicated for rating agencies as well as auditors, though they should have been more vigilant given the problems that all infrastructure companies are facing. To be fair to the credit rating agencies, they had flagged off a warning, though inexplicably, perhaps lulled by the blue chip projects, its partners, and its quasi-government nature, they failed to downgrade the debt early enough until the defaults actually started.

Equally, it is pretty scary that shareholders such as SBI, HDFC and LIC could not examine its books more closely and that the board and the CFO did not raise any red flags. It is particularly shocking because the man at the top - Ravi Parathasarathy - came from a blue chip banking background and had been dealing with finances of various risks his whole life.

What are the lessons going forward? One is of course that it makes little sense to have an NBFC, which also is in the business of actually executing infrastructure projects. A pure lending agency would have probably been monitored more closely by the RBI. Equally, execution agencies about to get into cash flow trouble are far easier to spot because they are also not raising debt as a lending NBFC.

Another point is that the government does need to figure out why so many infrastructure projects run into cash flow and other financial problems (which in turn creates problems for their lenders). This is a bigger problem because infrastructure is a long gestation business, while finances raised are for shorter tenures thus causing asset liability and cash flow mismatches.

Finally, it might make best sense to slowly wind up the IL&FS business after selling off its debt and paying of its asset instead of letting it exist with a rap on the knuckles.