The ruckus that has followed the recent credit downgrade at project financier Infrastructure Leasing & Financial Services (IL&FS) highlights how financial troubles at a single institution in India can set off a domino effect across the entire financial system. IL&FS and its subsidiary IL&FS Financial Services enjoyed high credit ratings and seemed to be a go-to name for short-term lenders until reports leaked out a week ago that the subsidiary had missed due dates on commercial paper, while the parent had defaulted on deposit dues to SIDBI. Thereafter, rating agencies ICRA, India Ratings and CARE swung into belated action to abruptly downgrade IL&FS and its subsidiary from high investment grade (AA plus and A1 plus) all the way to junk status (BB and A4). With the ratings falling off a cliff, the 30-odd mutual fund schemes holding a ₹3,500 crore exposure to IL&FS entities were forced to take sudden write-downs, jolting their investors. Domestic banks and insurers, also said to hold significant exposures to the group, may soon have to follow suit. IL&FS, meanwhile, is in parleys with its major shareholders LIC and SBI for a lifeline, which may not go down well with the latter’s policyholders and investors.

There are lessons for almost all financial market constituents from this episode. For rating agencies, it is a matter of concern that, though the stretched liquidity position of the group was known for some time, it took an actual default for them to revisit their investment grade ratings. Though the raters repeatedly flagged loan book concentration, high debt levels and the dire financial straits of group firms in their reviews, they seem to have pinned their hopes on IL&FS’ big-name promoters (LIC, Abu Dhabi Investment Authority, SBI, Central Bank) to bail it out of its troubles. This exposes the fragility of the ‘structured obligation’ ratings often handed out to weak entities hailing from marquee industrial groups. The mutual fund industry too does not come out of this episode smelling of roses. Instead of restricting their exposures to the high-risk paper to their ‘credit risk’ funds, fund managers also parked it with their liquid and low duration funds, despite marketing them as low-risk alternatives to savings bank accounts. Here, SEBI should revisit its recent fund categorisation rules to ring-fence these categories of debt funds from credit risks. For banks, this again drives home the risks of funding long-gestation projects with short-term money.

Overall, even if IL&FS manages to tide over this episode, it has underlined the need for institutional investors in the Indian bond market — banks, mutual funds, pension funds and insurers— to build their own capabilities for independent credit appraisal instead of over-relying on rating agencies for their investment calls. Of course, this does not absolve rating agencies of the need to to be proactive rather than reactive with their rating actions.

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