What is the issue?
- The Infrastructure Leasing and Financial Services (IL&FS) trouble exposes the weakness in India’s financial regulatory architecture.
- It calls for appropriate reforms in regulatory mechanisms as the consequences are widespread.
What happened to IL&FS?
- Infrastructure Leasing and Financial Services (IL&FS) is a large infrastructure finance company.
- Some of its subsidiaries defaulted on their debt as a consequence of which its credit was sharply downgraded recently.
- If tax-payer money is used to save IL&FS, it would be another drain on the Union Budget.
- Notably, the Centre's fiscal is already burdened by mismanagement and regulatory failures in the banking sector.
What went wrong?
- There were shortfalls in ensuring institutions in place to monitor and regulate systemic risks.
- IL&FS is a non-bank financial company regulated by the RBI.
- But the RBI does not have all the information to understand risk to other financial firms arising from its debt.
- Pension funds, provident funds, mutual funds and insurance companies hold the debt of IL&FS subsidiaries.
- But RBI does not regulate these and hence will not have the full picture.
- The RBI may know only about bank loans to the conglomerate.
- But the ripple effects of financial shocks can be felt across sectors and not just financial markets.
What does it call for?
- The failure of one company can create a risk to the financial system as a whole as witnessed from bankruptcy of Lehman Brothers.
- Such “systemic risk” needs to be monitored, as, if a firm is large, it is considered “too big too fail”.
- Even if not too big, if deeply integrated with the business of other firms, it may be “too networked to fail”.
- In either case, such firms and their real-time networks need to be monitored.
- For better response, the regulator must know who will get hit if such firms fail, by how much, and what will be the consequences.
- Such firms can be put under enhanced supervision and at all times there needs to be a full picture of their assets and liabilities.
- To ensure financial stability, this job needs to be given to an agency with powers to monitor risk-cutting across sectors.
What are the proposed reforms?
- Regulation - Financial Sector Legislative Reform Commission recommended in 2012, legislative and architectural reforms for financial regulation.
- 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, concerns raised by financial regulators are delaying the process of implementation.
- So as of now, if there is a trouble, the regulators will be let off but the government will have to bear the consequences.
- Resolution - Financial firms, both bank and non-bank, need to have an orderly mechanism for crisis resolution.
- The resolution corporation was proposed to be set up through the Financial Resolution and Deposit Insurance Act.
- This would have watched the company, and examined whether it is systemically important.
- It would have asked it to prepare a living will if needed, and then stepped in before the firm defaulted.
- But the opposition to the legislation led to the withdrawal of the Bill.
What next?
- Given the above, the options are now limited and the firm can be forced sold.
- But again the question of 'whom to' remains as the LIC is already buying up all the weak remains in the financial sector.
- Otherwise, IL&FS can be taken through Insolvency and Bankruptcy Code.
- This would mean its subsidiary firms that are non-financial firms could be sold one by one through the bankruptcy process.
- But none of these are easy or fast solutions; the regulatory mechanisms need a relook.
Source: Indian Express
