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By Somnath MukherjeeEven without the eerie coincidence of the 10th anniversary of the collapse of Lehman Brothers, there are enough straws in the wind to draw parallels between the iconic Wall Street bank and ILFS, the infrastructure finance major that has been struggling for survival in the last few days.
A (relatively) small but systemically important financial institution, funded largely via short tenure loans/bonds by wholesale investors, assets comprising illiquid, longer-dated securities, low loan-loss provisions, exposures to a range of other financial institutions (including a large insurance company) — “uncanny” would be an understatement to describe the similarities.
Thankfully, in this case, the ugliness is merely skin-deep.
The leverage involved is much lesser in ILFS compared to Lehman.
The biggest issue in 2008 was the predominance of credit derivative structures in bank balance sheets, which multiplied exposures far in excess of available assets underlying the derivatives.
Added to that were theoretical correlations of various derivatives, basis on which capital provisions were arrived at (a basket of uncorrelated or low correlation assets required less capital than a basket of assets with high correlations) — when the underlying assets developed weakness, it was found out that the theoretical correlations were of very little use as prices of all assets fell in a synchronised manner.
Net result was cascading credit exposures with very little capital cushion resulted in unforeseen meltdowns –– exemplified by Minibonds, an investment vehicle where the only Lehman exposure was that of a swap counterparty, and there was no issue with any of the explicit credit exposures.
Scenario in India generically, and with ILFS in particular, is very different.
First, credit derivatives are conspicuous by their absence –– hence providing an automatic cap on cascading exposures without capital.
Second, assets held by ILFS are not derivative instruments but real infrastructure assets.
Ergo, while the economic value of those assets might require viability haircuts, the amounts of haircuts required are in the realm of plausible linear estimations.
Not non-linear maths as was the case with the cascading exposures of Lehman – which resulted in a systemic meltdown of banks.
Last, there are potential credit and equity cushions available that mitigate the systemic risks posed to banks.
To start with, of the estimated Rupees 90,000 crore of debt on ILFS balance sheet, an estimated Rupees 4,000-5,000 crore are with mutual funds and a further Rupees 10,000 crore are with pension funds and insurance companies.
Given the near zero leverage in MF/insurance companies in India, technically the entire amount can be marked down without big systemic risk –– these investments are fully “equity funded” (that is, out of investor money without leverage) and form a very small proportion of MF/ insurance company AUMs (therefore, can be converted to equity without debilitating impact on investor fortunes).
Then, ILFS has a net worth of Rupees 7,400 crore (as of FY2018) which acts as a further cushion to take the first haircuts on its assets.
So, there is around Rupees 22,000-23,000 crore of potential capital cushion for ILFS’s Rupees 90,000 crore debt.
Finally, there is also the widely-discussed equity infusion by existing shareholders.
While it’s going to cause some pain, ILFS is rather far from being a systemic risk than Lehman ended up being.
The real issue is somewhat different.
The ILFS situation brings into sharp relief the ongoing discussion on the social contract of financial institutions.
Unlike the muchmaligned public sector banks, ILFS is a privately-owned and professionally-managed institution (majority shareholding is with private institutions, employees).
However, when the proverbial hits the ceiling, yet again, the burden of rescue has fallen on taxpayer shoulders.
As of now, options around bailing out the institution are predicated on state institutions (primarily LIC and SBI) infusing capital and/or opening up large credit lines.
This is neither the first, nor will it be the last case, that taxpayers will be asked (ironically for stability in their own lives – the default in Minibonds, eg, caused social unrest in large sections of East Asia, where the investment was sold to thousands of retail investors, including pensioners) to bail out a private financial institution.
It is rather ironic therefore how much of the “reform” narrative on financial sector revolves around privatisation and incentivising of the private sector.
When default setting of the sector is “private profits, social losses”, it is counterfactual, even silly perhaps to argue that privatisation is part of the solutions toolbox.
As the government, regulators and system work towards containing the ILFS fallout, it will be reasonable for the financial system to pause and think – “This time, it isn’t different” – just as a break from the groupthink that pervades today.
The author is managing partner head - products, investment strategy advisory and international business of ASK Wealth Advisors
