Moody’s Investor Services has said that rising liquidity worries at ailing IL&FS are credit negative for banks and debt market.
This observation comes in the backdrop of IL&FS' subsidiary IL&FS Financial Services being barred from accessing the commercial paper market due to delay in repayment of some of its obligations and IL&FS itself defaulting on a repayment of Rs 1,000 crore to the Small Industries Development Bank of India.
As of March-end 2018, debts incurred by IL&FS in the form of bank loans accounted for around 0.5-0.7 per cent of the overall banking system loans. The global credit rating agency said it does not expect the exposure of any rated bank to exceed 2 per cent of its loan book.
“The group's repayment risks will remain significant because of the weakening of its credit metrics,” the report said, adding that IL&FS infrastructure business is a root cause for the current distress.
“One particular asset challenge for banks in a potential IL&FS default comes from the company's complex corporate structure, which could result in high variation of ultimate losses across banks depending on where the banks' specific exposures lie,” it said, noting that IL&FS has a complicated structure, with the holding company at the top owning stakes in its financial services arm as well as in multiple subsidiary companies that operate its infrastructure assets.
IL&FS has a complicated structure, with the holding company at the top owning stakes in its financial services arm as well as in multiple subsidiary companies that operate its infrastructure assets.
For instance, IL&FS Transportation Network, which is the entity holding the group's transportation assets, was involved in 37 projects at the end of March 2018. These projects include a mix of operating assets and assets still under construction.
"Most of these projects are housed under separate subsidiaries. This implies that the eventual losses suffered by creditor banks in a default scenario could vary significantly and depend on the particular assets lodged within specific subsidiaries. A bank that lends to a subsidiary with a mature flows will be in a better position than a bank that lends to one with assets under construction," opined Moody's.
The agency cautioned that the group's repayment risks will remain significant because of the weakening of its credit metrics. Over the last decade, debt in the group has increased significantly on account of significant investments in new infrastructure ventures.
IL&FS' infrastructure business is a root cause for its current distress. It is a roads operator, and also has a few other transportation projects such as metro rail operations. Some of these projects have been affected by rising financial distress, including traffic shortfalls below projection, cost overruns and compensation disputes with regulators.
"The banking system does have meaningful exposure to the overall roads sector. However, we believe that most of the weak exposures in this sector are already non-performing loans (NPLs) in banks' books.
"Banks' exposure to IL&FS's weak road projects may not have been recognised as NPLs so far on account of an expectation of parental support," Moody's said in a statement.
Apart from their direct loan exposure, banks are also vulnerable to an IL&FS default through the potential impact on India's domestic debt markets, the agency cautioned the agency.
As of March 31, IL&FS had outstanding debentures and commercial papers, which accounted for 1 per cent and 2 per cent, respectively, of India's domestic corporate debt market. Furthermore, most of these papers were issued by entities that had high domestic ratings until recently.
Moody's elaborated that: "Because of their high ratings, these securities would have met the holding eligibility criteria for most of the institutional investors like mutual funds, pension funds and insurance companies. Hence, a default on these instruments could affect a wide range of market participants.
"One particular risk to banks is a decline in the credit standing of their borrowers that are sensitive to market confidence. In particular, finance companies rely on debt capital markets as a major funding source and are vulnerable to a tightening in overall market liquidity," it said
Given that around 5 per cent of banking system loans are made to finance companies, the agency felt that a deterioration in the credit profiles of finance companies will have a negative impact on banks as well.
"At the same time, the risk of a contagion is mitigated by our assessment that the underlying solvency issues, which have led to the liquidity issues, are idiosyncratic to IL&FS and are not prevalent in the finance companies sector.
"Unlike IL&FS, finance companies operate in the retail finance segment where asset quality remains sound. This lowers the risk of a contagion," it said.