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Until India's lending system is fixed defaults like IL&FS will continue: View


By Uma Shashikant


The Serious Frauds Investigations Office (SFIO) filed its first chargesheet in the ILFS case at the Mumbai sessions court on 30 May. The documents reveal the sad state of credit markets in India and how deeply the system is broken.

The institutional framework for credit works on principles of checks and balances. Borrowers put forth their audited financial statements as proof of assets, its funding and deployment and profits from such activity. An auditor certifies these representations as true and fair. A credit rating agency examines these numbers, probes the business and market environment in which the borrower operates, and assigns a rating.

The borrowing is secured by a charge on assets, and debenture trustees and the Board of directors of the borrowers are responsible for ensuring that the funds are put to the use they are intended for. Auditors have to report that end use of the borrowed funds on an ongoing basis is as per terms of borrowing.

The borrowing is standardised into financial instruments called debentures, the issue of which is subject to regulatory disclosures, and to listing rules of exchanges. The norms ensure that only eligible borrowers with strong financials tap the markets. They also ensure that disclosures and transparency in information enables outsiders to buy the debentures and lend money to the borrower.

The lender, typically an institutional investor such as a provident fund, financial institution, mutual fund and such rely on these representations to buy the debentures. They rely on financial statements, credit rating, and the disclosures in the offer document.

Whether the entity itself can continue to be in the market, borrowing public funds for its business, is a matter of oversight by the RBI. These entities are not end users of the funds they mobilise; they instead lend it to many other borrowers.

The risks of default and leverage is high. It means serious problems in the economy when a chain of lenders and borrowers face default. RBI inspects the organisation, its procedures and processes for lending, the quality of its assets, and veracity of its numbers. The license to operate is issued by RBI which holds the powers to revoke it too.

Does this framework prevent default? No. Default is not a predictable event and factors that lead a borrower to default are too many to control and prevent. Frameworks are meant to create a system of sound lending practices that enable a lender to take on some credit risk while lending, while preserving the robustness of the balance sheet. In a financial firm, this is done in two ways: One, a default triggers provisioning. A part of the profit has to be written down to allow for the possibility that some assets cannot be recovered or are worth lesser than what the books show. Two, capital adequacy is the buffer that sets the limit to how much the quality of assets can deteriorate.

An NBFC with say Rs 15 of equity capital, and Rs 85 of borrowings, can make loans of Rs 100. However, any drop in the value of loans from default, will begin to eat into the equity capital. Whether the Rs 85 can be returned without default depends on how much of the Rs 100 is good to recover and how much the equity capital covers that shortfall.

The ILFS case shows how every brick in this framework was broken by a coterie of unscrupulous managers at the firm. The financial statements were falsified and misrepresented the real state of affairs. Auditors now face the prospect of ban and suspension of business arising out of this lapse. The rating agencies have been pulled up for failing to see the default risks in the business.

What ILFS did is not exceptional. It is a rampant practice in India. A business creates a large network of entities. ILFS has 250 subsidiaries. It then borrows using one balance sheet and diverts the funds to other entities linked to it. It then recklessly lends to projects, businesses, and ideas for personal favours. SFIO describes how this rot had spread with personal payoffs to sanctioning authorities within the firm. There is a web of transactions created across multiple firms.

Then as borrowers failed to pay, their loans were not provisioned, but “evergreened.” This means, a new loan took the place of an old loan, through an unscrupulous transaction where loans were made to defaulters to repay older defaulting loans. So there was not just reckless lending, but also unscrupulous cover up of defaults and perpetuation of lending to defaulting entities. ILFS built this number up to a staggering estimate of Rs 90,000 crore.

Such largescale malpractice could not have happened without the connivance of all entities listed in the institutional framework above. Auditors do not seem to have checked use of funds; there is evidence to show they knew funds were being misused and diverted. They certified financial statements that should have been heavily qualified. Rating agencies did not analyse the web of related companies and transactions which would have brought to light the risks in the balance sheets. Nor did they find out that the net worth and stability numbers did not add up.

The investors who subscribed to the debentures are all institutional entities. In one of the much publicized tranche of funding, the list of the top 50 subscribers is made up of provident funds of various business entities. It is the hard-earned retirement funds of many employees that has been risked in the bonds of an unscrupulous financial entity.

A trial and possible conviction of the criminals awaits. But what needs fixing is the broken institutional structure for lending. ILFS was promoted by marquee names and has been grounded by fraudulent practices. The SFIO chargesheet shows the modus operandi and ILFS is not the only perpetrator. The government and regulatory agencies should act to fix this rot and not wait for the next big default.

(The author is Chairperson, Centre for Investment Education and Learning)





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