A major economic crisis was anticipated in September 2018 when the Indian Stock market shed more than 1100 points in a single day. Despite the recovery that followed, there have been long lingering effects in the Indian economy as shares of major NBFC’s, housing finance companies, as well as mutual funds, have been hit besides other impacts on the market.

The primary cause of these events has been the IL&FS limited, the giant company that defaulted in its payment obligations leading to a number of contagion effects. An investigation into what is being termed as a major crisis has brought to light many controversial issues viz a viz the system of credit rating, auditing and regulation in India.

What is Infrastructure Leasing & Financial Services (IL&FS) Limited 

The Infrastructure Leasing and Financial Services (IL&FS) Group was founded in 1987 with a number of subsidiary companies for infrastructural development and financing. It has a variety of institutional shareholders with LIC (25.34%), Japan’s ORIX Corp. (23%), Central Bank, HDFC and SBI among the most prominent ones. More than thirty years old now, it is a mammoth conglomerate that has funded huge projects worth around 1.8 trillion rupees including India’s longest Chennai-Nashri tunnel by championing the Public Private Partnership model.

As an established player in the field, IL&FS has been granted exemplary credit rating for the debt instruments issued by it. It, therefore, attracts huge investments by engaging in long-term borrowing from the banking sector as well as short-term borrowing from NBFC’s.  Since IL&FS invests money in long-term infrastructure projects, an asset-liability mismatch began to occur as short-term loans needed repayment. This translated into an increase in the debt to equity ratio, a higher repayment liability and eventually, the assets became illiquid.

il&fs graph

Moreover, after the Land Acquisition Rehabilitation Resettlement Act was passed in 2013 the cost of the infrastructure projects funded and operated by IL&FS has shot up as fair compensation needs to be paid to the landowners. Also, a large amount of money has been locked up in the arbitration done for the disputes between Government of India and IL&FS with the latter demanding compensation of more than 90 billion dollars. The fact that IL&FS also serves as a shadow bank, engaging in lending and borrowing outside the banking sector to invest in high-risk projects has also resulted in increased financial pressure on the company.

Unfolding the Crisis

Several factors led to a huge defaulting by the company on its payment obligations to SIDBI. These were to the tune of around 300 crores along with a high number of defaults with inter-corporate deposits. Eventually, SIDBI approached the RBI which then initiated an audit into the accounts of IL&FS.

As soon as the news went public, the Stock market took a serious hit, the credit ratings of IL&FS were immensely downgraded creating an atmosphere of insecurity among the investors in the market. Not only did the RBI try to stabilize the situation and infuse liquidity in the market by conducting open market operations, but the central government stepped in too. It filed a petition in the National Company Law Tribunal (NCLT) under the Section 241 and 242 of the Companies Act to overtake the board of IL&FS over grounds of financial mismanagement and replaced it with a new six-member board.

The Role of Auditors

As the crisis has unraveled, the role of auditors has come into question with respect to their appointments as well as reports.

After the government took over the IL&FS group, its statutory auditors received show cause notices by ICAI for ‘failing their duty’ and ‘misrepresenting their facts’Deloitte served as the statutory auditor of the group before and during 2016-17, followed by SRBC in 2017-18. Affiliates of EY and KPMG also served as auditors of the subsidiaries.

The Securities and Exchange Board of India (SEBI) has been looking into the role of these auditors and as suggested by its Chairman Ajay Tyagi, it will take action against defaulting auditors. Even the Serious Fraud Investigation Office is looking into the various methods for credit rating as a part of its investigation of the crisis. The auditors, on the other hand, have tried to insulate themselves by highlighting that they had raised a few red flags and identified anomalies but they could only issue disclaimers or modified opinion that couldn’t prevent this unfortunate turn of events.

The Consequences

Ten years after the global economic crisis, the IL&FS crisis has been termed as ‘India’s Lehman Moment’. It has not only devastated the stock market but also led to the shortage of liquidity. Past the immediate consequences, this crisis throws light over the flaws that exist within the Indian auditing, regulation and credit rating systems.

Under the current system, the lack of periodic rotation of auditing firms causes the appointed auditors to produce favorable reports and overlook faulty decisions and encourage corrupt practices that were observed in the workings of the IL&FS group. Consequently, the reports are far from being truly accurate in nature thereby reducing their effectiveness in regulating the holding companies.

Moreover, a failure of this nature has adverse effects on the investment climate in India as it derails investor confidence and calls into question the creditworthiness of the borrowers. Even though timely action prevented further collapse of the Indian economy, the crisis has definitely put the government’s plans for infrastructural development into jeopardy.

15 Comments

  1. The Article deconstructs the issue very well about the IL & FS crisis also it’s reader friendly.

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