It’s broke, fix it

The IL&FS trouble exposes the weakness in financial regulatory architecture. Reforms are called for

Written by Ila Patnaik | Updated: September 21, 2018 12:10:08 am

If a firm is large, it is considered “too big too fail”.

A large infrastructure finance company, Infrastructure Leasing and Financial Services (IL&FS), is in trouble. Some of its subsidiaries defaulted on their debt. As a consequence, it was sharply downgraded recently. We do not really know the system-wide implications of an IL&FS default. If tax-payer money is used to save IL&FS, it would be another drain on the Union Budget, already burdened by mismanagement and regulatory failures in the banking sector.

This situation need not have arisen had we put in place institutions that monitor and regulate systemic risks such as a systemic-risk regulator and a resolution corporation. There were attempts at many levels to put such laws and institutions in place. Laws were proposed, Budget announcements made and task forces created. Turf wars, and the misplaced view that India was saved from the crisis and therefore needs no reform managed to scuttle the proposed reform. A famous financial regulator’s stance on the proposed reforms was “If it ain’t broke, don’t fix it!”

The most important lesson from the bankruptcy of Lehman Brothers was that the failure of one company can create a risk to the financial system as a whole. Such “systemic risk” needs to be monitored. If a firm is large, it is considered “too big too fail”. Even if it is not too big, but so deeply integrated with the business of other firms in the financial sector, it may be “too networked to fail”. In either case, such firms and their real-time networks need to be monitored. To understand how to respond to trouble in such a firm, the regulator must at all times know who will get hit if this firm fails, by how much, and what will be the consequences of such a failure. At all times there needs to be a full picture of their assets and liabilities. These firms can be put under enhanced supervision.

To ensure financial stability, this job needs to be given to an agency with powers to monitor risk-cutting across sectors. In this instance, IL&FS is a non-bank financial company regulated by the RBI. But the RBI does not have all the information required to understand risk to other financial firms arising from its debt of Rs one lakh crore. It may know about bank loans to the conglomerate. But pension funds, provident funds, mutual funds and insurance companies hold the debt of IL&FS subsidiaries. Since the RBI does not regulate them, it will not have the full picture.

A similar situation arose post-Lehman when AIG, an insurance company, witnessed distress. No one knew who would not be paid if AIG defaulted. This led to the understanding that today’s financial markets do not lend themselves to only sectoral regulation. The ripple effects of financial shocks can be felt across sectors and all those need to be known before we decide how to handle a possible default.

The Financial Sector Legislative Reform Commission, when submitting its report in 2012, drawing upon lessons from the crisis, and analysing the present legal framework in Indian financial regulation, had recommended legislative and architectural reforms. This included a body that would monitor systemic risk. The Financial Data and Management Centre would have the legal powers to collect all regulatory data along with sectoral regulators. The 2016-17 Budget announced the setting up of such a data centre and consequently a draft bill was proposed. However, turf issues of financial regulators ensured that this important initiative did not see the light of day. Unfortunately, if there is trouble, these regulators will go scot-free while the government will have to bear the consequences.

Another equally important lesson from the global financial crisis was that in such times financial firms, both bank and non-bank, need to have an orderly mechanism for their resolution so that they can be sold as living firms with minimum cost to the economy and the taxpayer.

The proposed resolution corporation, to be set up through the Financial Resolution and Deposit Insurance Act, would have been watching the company, examined whether it is systemically important, asked it to prepare a living will if needed, and then stepped in before the firm defaulted. So today, if reforms based on lessons from the global financial crisis had been allowed, there would be an orderly mechanism for a resolution of a financial firm. The push back from various quarters opposing the FRDI bill led the bill to be withdrawn. Today the options are limited. The firm can be forced sold. But to whom? LIC, which is already buying up all the carcasses in the financial sector? Or IL&FS can be taken through IBC. This would mean its subsidiary firms that are non-financial firms could be sold one by one through the bankruptcy process. None of these are easy or fast solutions.

In the absence of a good legal framework to resolve a complex financial firm, a temporary solution involving a crack team and a war room to address the problem might be the best option. Hopefully, it will be able to manage the situation without paying a big cost. The IL&FS trouble exposes the weakness in India’s financial regulatory architecture. This episode should increase the urgency with which the required reforms are brought back on the table.

The writer is a professor, National Institute of Public Finance and Policy.

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