[Editorial Analysis] It’s broke, fix it

Mains Paper: 2 | International relations

Prelims level: Infrastructure Leasing and Financial Services

Mains level: The IL&FS trouble exposes the weakness in financial regulatory architecture.

Context

• A large infrastructure finance company, Infrastructure Leasing and Financial Services (IL&FS), is in trouble.

• Some of its subsidiaries defaulted on their debt.

• If tax-payer money is used to save IL&FS, it would be another drain on the Union Budget.

• 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.

• A famous financial regulator’s stance on the proposed reforms was “If it ain’t broke, don’t fix it!”

Lesson for bankruptcy

• 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”.

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.

• 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.

• It may know about bank loans. 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.

• The Financial Sector Legislative Reform Commission 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.

• Another equally important lesson from the global financial crisis was that in such times financial firms, both bank and non-bank.

Way forward

• Its 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.

• 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.

• The temporary solution involving a crack team and a war room to address the problem might be the best option.

• 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.

Share article