Why India loves a crisis

Jim Collins, in his 2009 bestseller How the Mighty Fall, describes the five stages of decline a big company goes through. It starts with “Hubris Born of Success”; goes on to “Undisciplined Pursuit of More”; it is followed by “Denial of Risk and Peril”; then comes “Grasping for Salvation”, and finally, “Capitulation to Irrelevance or Death”. Sometimes, just sometimes, a company can recover from “Grasping for Salvation” to “Recovery and Renewal”. The sharp decline of the once blue-chip Infrastructure Leasing & Financial Services (IL&FS), one of India’s largest non-banking finance companies (NBFC), nine years later seems to exemplify what Collins had written.

Unfortunately for IL&FS, after a series of defaults on its debt instruments in September and October last year, there was no“Recovery and Renewal” but near “Capitulation to Irrelevance or Death”. The reason: the mandate of the new IL&FS board headed by billionaire banker Uday Kotak is not just to clear up the mess, but to also recover much of the ₹91,000-crore debt piled up over the years, through the sale of its assets. Hence, even if IL&FSwere to survive, it will only be a shadow of its past—not the mega entity that operated across the globe with projects from Africa toChina ranging from highways and sanitation projects to renewable energy through its 348 subsidiaries and associates.

It has been over 12 months since the IL&FS fiasco came to light, but India is still reeling from the trail of destruction left in its aftermath. Banks, mutual funds, and other financial institutions have turned risk-averse and so have investors. NBFCs, which were responsible for driving nearly 25% of the incremental credit in the past five years, mostly to the unbanked sector, suddenly find themselves facing a cash crunch despite adequate liquidity being present in the market. Badly-run NBFCs and wholesale lenders like housing finance companies that borrowed short-term to lend long-term—those with an asset-liability mismatch—suddenly found banks (which lend money to them) and mutual funds (which subscribed to their debt instruments) unwilling to roll over their short-term maturing debts, thereby creating a crisis.

As the credit market froze because of the IL&FS fiasco, even well-capitalised NBFCs found liquidity hard to come by. And even where funds were available, it came at a price, with even Muthoot Pappachan Group, a leading NBFC, seeing its borrowing cost going up by 50 basis points. “It is not really a liquidity problem, but a trust issue because financiers have started questioning the creditworthiness of these companies and taking a re-look at their existing investments,” says Sunil Kumar Sinha, principal economist at India Ratings and Research, a rating agency. There was a reason why the financiers became apprehensive: If IL&FS—a “core investment company” registered with the Reserve Bank of India (RBI) and with top government agencies like Life Insurance Corporation of India and State Bank of India on its board—could collapse, anything was possible in the NBFC space.

That there is little liquidity squeeze is clear from the fact that in FY19, the RBI injected ₹2.98 lakh crore into the system through open market operations.

But all is not lost, and this crisis—like the earlier ones—has a silver lining. For example, the 1991 economic crisis, precipitated by the faulty economic policies of the previous governments and crude oil prices touching record levels because of the Gulf War, led to double-digit inflation and unsustainable debt levels. When P.V. Narasimha Rao took over as prime minister on June 21, 1991, India’s foreign exchange level had shrunk to cover only two weeks of imports, when it should have been six times that amount. This led to structural reforms, which included abolition of all industrial licensing other than those of strategic or environmental importance; pruning of industries reserved for the public sector from 18 to 8; abolition of import controls on intermediate and capital goods and components; and phased reforms of direct and indirect taxes, etc. Similarly, the bad loans crisis of 2013-14 led to the RBI ordering an asset quality review of banks, and the implementation of the Insolvency and Bankruptcy Code.

These trying times will force the NBFC sector and the ecosystem it supports to shape up, experts say. It will make them more transparent and sustainable. The severity of the crisis has forced the government and the RBI to intervene nearly 14 times in the past two months. A recent report by Antique Stock Broking explains that the interventions were “two-pronged”. While one set looked at providing more funds for liquidity-strapped NBFCs, the other “aimed at overhauling the regulatory framework to ensure a healthy future”. Says Digant Haria, one of the co-authors of the report: “While regulations around leverage, ALM [asset-liability management], and liquidity management could ensure some short-term pain, they will ensure healthier functioning of NBFCs in times to come.”

It has not only brought about significant changes in the policies of the government and those of the regulators such as the RBI and the Securities and Exchange Board of India (SEBI), but has also changed the way credit rating agencies, audit firms, and independent directors on the boards of these companies function.

The government began its reform agenda by allowing the RBI to regulate troubled housing finance companies, taking them out of the purview of the National Housing Bank. Today, the central bank can supersede an NBFC’s board, suspend the executive management of the company, and order an asset quality review—putting these entities on a par with banks. “These measures will not only ensure greater scrutiny and monitoring by the RBI, but also put the NBFC sector on a far stronger footing,” says Amir Ullah Khan, professor of economics at Hyderabad-based NALSAR University of Law. Second, to ensure greater liquidity for the better-run NBFCs, banks have been allowed to increase their exposure limit to a single borrower from 10% to 15%. Such a measure will not only release nearly ₹15,000 crore in the market for NBFCs, but also allow the more robust entities to borrow more from banks. Third, risk-weight guidelines—the money that these companies need to keep aside in case of a crisis or some unfortunate event—too has been harmonised. Firms will now be assigned a risk weight depending on their credit rating—those with a higher credit rating will have to keep aside a lower amount, while those with lower ratings have to maintain a bigger security cover.

These measures will be a huge positive for highly-rated loan companies like Muthoot Finance, Muthoot Capital, Manappuram, Bajaj Finance, etc., because banks were unwilling to lend to them earlier since they all had 100% risk weight, says the Antique Stock Broking report. Rating agencies, too, are under the scanner. After being chastened by SEBI for negligence, they will have to be more vigilant with their assessments about the liquidity profile of NBFCs. Rating agencies must check whether AAA-rated companies can honour their debt obligations for the next three years. AA-rated ones must have enough to cover two years and those rated A one year.

“So rating agencies will have to see that AAA-rated NBFCs have enough cash, cash equivalent or line of credit from banks to service their maturing debt for the next three years,” says Sinha. Rating agencies will have to monitor the financial health of these companies on a regular basis, and not once a year; the NBFCs too will be forced to save a much larger amount to avoid defaults.

In every rating commentary, agencies will have to specify why they have rated a company’s capital as “sufficient, adequate, moderate, or stretched”, defined in terms of interest coverage ratio. It is a financial ratio that measures a company’s ability to make interest payments on its debt in a timely manner. While the RBI has set no defined guidelines to define these terms, rating agencies have developed their own set of parameters. That’s not all. In case a company delays raising its long- or short-term borrowing by more than three months, rating agencies will have to repeat their surveillance process and issue a new rating letter. Earlier, the same letter would suffice if there was no major development in the company. Moreover, rating agencies are now expected to produce a no-default certificate every month for every repayment that is due on the very day of that month.

For auditors too, it is their first wake-up call after the Satyam crisis. Never before has their work come in for so much criticism, nor have they found themselves so harshly treated for their lapses. In fact, the Serious Fraud Investigation Office has charged Deloitte Haskins & Sells and BSR & Associates for their failure to disclose the true financial health of IL&FS and the Ministry of Corporate Affairs is seeking to ban them from undertaking audits for five years. “Auditors should be made far more accountable for their lapses because not only are they the first external eyes to look at the books of the companies, but also because other stakeholders—whether it is rating agencies, independent directors, or others—depend on their audited results to take decisions,” says Prime Database Group managing director Pranav Haldea.

Also, it won’t be easy for auditors who want to play safe by resigning from accounts seen as risky, like Price Waterhouse & Co. did by pulling out as auditor of Anil Ambani-led Reliance Capital and Reliance Home Finance. The new SEBI guidelines say auditors have to give reasons for resigning from a company, which will be filed with the exchanges. If auditors resign 45 days before the end of a quarter, they will have to do a limited review of the company’s books. More importantly, the government has established the National Financial Reporting Authority on the lines of the Public Company Accounting Oversight Board of the U.S. It not only takes away the power of the existing regulator, the Institute of Chartered Accountants of India, by conferring all the powers of establishing and enforcing accounting and auditing standards and oversight of the work of the auditor to the new body, but also calls for more transparency. In case professional misconduct is proved, auditors will have to pay a hefty fine and can be debarred for six months to 10 years.

It is becoming tougher for independent directors, too. “The risk-reward ratio is increasingly getting skewed and independent directors will move towards better-governed companies,” says Amit Tandon, co-founder and managing director of Institutional Investor Advisory Services, a proxy advisory firm. NALSAR’s Khan adds that independent directors these days want to see evidence, not just declarations, about “whether the management is aware of the changing external environment and regulations, especially if it is an infrastructure company. After all, there is little difference between an independent director and executive directors ... because both of them are liable for lapses.’’

What does it mean for NBFCs? Not only will these entities have to be completely transparent in their dealings, they will also keep their boards updated about any development, says Khan. Yet, that may not be enough for them to find good independent directors as, like investors, they too are wary of joining NBFCs.

“More and more NBFCs will have to take the initial public offering route to raise finances because private placements will be hard to come by,’’ says Haldea. But the crisis will bring its own rewards.

(This issue was originally published in the November 2019 issue of the magazine.)