Financial Mechanisms in Urban Development: A Case of IL&FS | Architectural Research Seminar 2020

Semester 7 | Architectural Research Seminar 2020

Financial Mechanisms in Urban Development: A Case of IL&FS and its Woes

Guide: Dr. Leon A Morenas Authors: Aparna Chandgothia Chanpreet Singh Rajat Raj Romila Raj Sanika Paliwal Shivam Yashwant Tandale

SCHOOL OF PLANNING AND ARCHITECTURE, NEW DELHI

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Semester VII - Architectural Research 03 December 2020

Seminar Research Paper Guide: Dr. Leon A Morenas Aparna Chandgothia Chanpreet Singh

Rajat Raj Romila Raj

Sanika Paliwal Shivam Tandale

Financial Mechanisms in Urban Development A Case of IL&FS and its Woes

Abstract: This research aims to study the financial mechanisms involved in the development of urban infrastructure - understand critical nodes in the process of raising capital, investment in projects, recovery of capital, and the complex relationship between them. Further, we study the recent financial crisis of IL&FS and its impact on India’s economy and the public in general.

This study was carried out by means of qualitative analysis of readings of various events in the past which highlight the roles of individual nodes identified in this process. The study starts with an introduction to the need for private sector participation in public sector infrastructure projects - its advantages and drawbacks in certain cases. The first part of the paper examines the role of each node in the entire process of infrastructure development, ranging from planning and financing to the execution of the project. Some of the significant examples are the redevelopment of Paris in the 1850s, Lehman Brothers crisis in 2008, DND flyover case in the 2010s, and the Summer Olympics hosted by Rio in 2016. The second part scrutinizes the case of IL&FS, the crisis and its impact on various sectors of our economy, along with an example of the GIFT city project in Gujarat in 2007. The paper concludes with an understanding of how the financial mechanism of debt financing has multiple loopholes, on paper as well as in real life, which renders the entire process futile.

Keywords: Economy, Privatization, Debt finance, Urban infrastructure, Credit-Rating Agencies, Lehman Brothers crisis, IL&FS, GIFT city.

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List of Abbreviations: ADIA - Abu Dhabi Investment Authority AMRUT - Atal Mission for Rejuvenation and Urban Transformation BOOT - Build-Own-Operate-Transfer CARE - Credit Analysis & Research Ltd CBI - Central Bank of India CDO - Collateralized Debt Obligations CFS - Centre Funded Scheme CPs - Commercial Paper CRA - Credit Rating Agency DND - Delhi-Noida-Delhi DPIIT - Department for Promotion of Industry and Internal Trade EY - Ernst & Young FDI - Foreign Direct Investment FONRWA - Federation of Noida Residents Welfare Associations GDP- Gross Domestic Product GIFT city - Gujarat International Finance Tec-City GUDC - Gujarat Urban Development Corporation HDFC - Housing Development Finance Corporation ICDs - Inter-Corporate Deposits ICRA - Investment Information and Credit Rating Agency IFSC - International Financial Services Centre (IFSC)

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IL&FS - Infrastructure Leasing and Finance Services INR - Indian Rupee IOC - International Olympic Committee IRDA Insurance Regulatory and Development Authority LIC - Life Insurance Corporation MOU - Memorandum of Understanding MoUD - Ministry of Urban Development NBFC - Non-Banking Financial Company NCDs - Non- Convertible Debentures NCLT - National Company Law Tribunal NPA - Non-Performing Asset NPS - National Pension System NTBCL - Noida Toll Bridge Company Ltd PIL - Public Interest Litigation PMAY - Pradhan Mantri Awas Yojana PPP - Public Private Partnership RBI - Reserve Bank of India SBI - State Bank of India SEBI - Securities and Exchange Board of India SEZ - Special Economic Zone TOD - Transit Oriented Development ULB - Urban Local Body UTI - Unit Trust of India

List of Figures: 1. Page 12 - Diagram showing the relationship between the nodes in financial mechanisms of infrastructure projects 2. Page 14 - Diagram showing the process linked with CDOs 3. Page 16 - Major shareholders of IL&FS 4. Page 18 - Timeline of events with IL&FS since the establishment 5. Page 20 - Increase in the debt-to-equity ratio in the case of IL&FS (from 2015-2018)

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Table of Contents ______________________________________________________________________________

I. Financial Mechanisms in Urban Development

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Introduction

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Debt and Debt-financing

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Risks undertaken by the government and private sector

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Auditors

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Credit Ratings and their Agencies

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Regulatory Bodies, Arbitration, and Judiciary

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Conflict of Interest

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II. The case of IL&FS

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Overview

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Asset Liability Mismatch

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Impact of the crisis

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GIFT city

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Conclusion

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Acknowledgments

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Bibliography

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I. Financial Mechanisms in Urban Development ______________________________________________________________________________ Introduction The infrastructure sector is a great booster in any developing nation’s economy. Likewise, is the case of India, which is the second most populous country in the world after China, and one of the world’s fastest-growing economies (Dash and Sahoo, 2010). Infrastructure and construction account for being the second-largest economic activity which has been growing rapidly in India. Adding to the momentum of this growth, the production of machinery has been on a rise and has helped in improving rail, road, and port networks. India’s GDP (Gross Domestic Product) was growing at a rate of around 8% for the first decade of the 21st century, and it was predicted that India would become the fifth richest country by 2020, and the third richest by 2025 (India’s industrial structure - Case study - emerging and developing country India - OCR - GCSE Geography Revision - OCR). But reality has deviated from the math done on paper, where there is a huge gap between the potential demand of amenities that this huge population needs to sustain and the available supply of these amenities. Lately, the Indian economy has been showing signs of overheating because of ever-increasing urbanization and basic infrastructure constraints.

However, the Government of India has welcomed the challenge of urbanisation and has proposed projects that would help develop the nation. It is estimated that as of 2030, the urban population might rise to 40% of the total population (in 2030) with a contribution of 75% to the GDP, as compared to 31% from the last census with a contribution of 63% to the GDP. To provide for the increased demands, the Government of India planned the “Smart City Mission” in 2015 (“Smart Cities : Ministry of Housing and Urban Affairs, Government of India,”), whose core objectives include delivering basic amenities like adequate water supply, electricity and sanitation, along with increased emphasis on digitalization, and building a sustainable and secure environment in our cities through Transit Oriented Development (TOD), Housing for all projects like Pradhan Mantri Awas Yojana (PMAY), and Atal Mission for Rejuvenation and Urban Transformation (AMRUT) (Kukreti, 2018). This operation is a Center Funded Scheme (CFS) and would receive financial support from the Central Government along with a significant contribution from the State/ULBs (Urban Local Bodies). Other than this, balanced funds are to be channelized via innovative finance mechanisms like municipal bonds, or Pooled Finance Mechanisms.

The government has envisioned a spend of INR 102 lakh crores for a span of five years beginning in 2019-20 and reaching out across 23 sectors, where the private sector is relied 4

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upon to contribute 22% to the absolute spend (PTI, 2019a). Since the 1990s, governments all over the world have been encouraging the use of FDI (Foreign Direct Investment) in various sectors of infrastructure. Likewise, India also underwent major economic reforms encouraging Liberalisation, Privatisation, and Globalisation (“Liberalization, Privatisation and Globalisation,” 2018). FDI helps in bridging financial gaps between the quantum of funds needed to sustain a level of growth and domestic availability of funds. It is estimated that the “Foreign Direct Investment in the Construction Development sector alone (townships, housing, built-up infrastructure and construction development projects) stood at US$ 25.66 billion during April 2000 to March 2020, according to the Department for Promotion of Industry and Internal Trade (DPIIT).”(IBEF, 2020) The costs for the development of all these projects is enormous, and the government often needs financial support from the private sector through Public-Private Partnerships (PPP).

Debt and Debt-financing The necessary funds for development of infrastructure projects can be raised by either of two methods- equity financing and debt financing. Equity financing involves giving away part-ownership in exchange for money. The advantage is that no repayment is required, whereas the disadvantage is that part ownership is transferred, regaining which will probably be more expensive in the future. Debt financing comprises of borrowing money (eg. loans) to be repaid with interest in due course of time. The advantages of this system are that ownership is not diminished and that it provides a leveraging effect due to the tax-deductible interest, which results in higher profits. Infrastructure projects are usually based on debt-financed capital. The hefty size and scale of such projects require sound decisions of where one wants to borrow money from.

Two of the fundamental parties in the system of debt financing are the creditors (lenders) and the debtors (borrowers): Creditors are the banks, investors, shareholders who lend the money to debtors at a certain interest rate. For infrastructure development, the creditors generally lend the funds to specific groups working with infrastructure. These creditors choose to diversify their portfolio, i.e. they do not invest in individual projects, since that would be high-risk investments (all eggs in one basket situation). They choose to invest in Infrastructure Leasing & Financial Services (IL&FS) and similar companies, which work on a diversified portfolio of projects, thereby reducing the risk involved in the investment. These creditors also usually lack the specialised knowledge to work in infrastructure projects.

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The debtors who dabble with infrastructure, are usually private sector companies which specialise in the field. Making profits is their primary aim. They borrow money from the creditors as short term loans (eg. in the form of commercial papers for a period of 6-12 months). This is advantageous to them due to the low-interest rates. They invest this borrowed money in long-term projects at a higher interest rate, which gives them a high net income margin. In order to repay their debts, they have to roll over their liabilities by borrowing from another investor to repay an older debt. This is not prudent financing, for it leads to an asset-liability mismatch - borrowing short term and investing long term (Chanda, 2019). If creditors lose confidence in these debtors, they will not advance more loans, which will not allow them to roll over liabilities, and they shall default on loan repayments.

Debt financing was first introduced during the redevelopment of Paris in the 1850s - The chapter “Paris” from the book The City in Mind: Notes on the Urban Condition, by James Kunstler (published in 2001), describes the effort that went into transforming the city of Paris from an unsanitary and dilapidated place to the beautiful and tranquil city the world cherishes today.

The government’s treasury lacked the funds needed for full-scale city redevelopment. This was one among the many reasons why Georges Eugene Haussmann, the administrative chief of the empire, crafted the method of debt financing. The government’s procedures were tedious and slow and did not permit debt-financing. Therefore, Haussmann’s method was unauthorized and disguised.

His system involved paying contractors in instalments with a proxy bond for a “completed” project, which in reality had not been started yet. These bonds were exchanged by them at the government’s mortgage bank for cash. This allowed Haussmann to circumvent the then government for authorization for any project. The system was made complicated to conceal the money trail back to him, and he was the sole authority raising credit for the projects in Paris (Kunstler, 2001, chap. Paris).

Paris is one of the most successful and promising results of debt-financing for infrastructure projects. It can be observed, however, that the role of the government in this financial mechanism has evolved over time. From being oblivious and averse to deficit financing - they have imbibed it today into their economic models, and tax incentives make debt financing the preferred option for infrastructure financing.

Moreover, governments today seize every opportunity to attract investments by the private sector, which are largely debt-financed. One seemingly remarkable method to attract international investments and develop world class infrastructure is to host international sporting events like the Olympics. Developing nations resort to these events in hopes of building the nation. However, it sometimes leads to more problems than solutions, like in the recent case of 6

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Brazil. Brazil was awarded the opportunity to host the FIFA World Cup championship in 2014 and the Summer Olympics in 2016. Hosting two consecutive international sporting events was a huge task at hand that even developed countries had not undertaken, let alone developing countries like Brazil. The International Olympic Committee (IOC), however, felt that these events were important for a developing country to rise on the world platform and promote nation-building among its people - which will benefit the economy as well. These events led to the exact opposite - loss of faith of its citizens and a financial crisis. The development projects constantly ignored the infamous favelas of Brazil, which are low-income informal settlements.

They symbolise the stark socio-economic disparity in Brazil, which is one of the highest in the world. No attempts were made to improve facilities surrounding these settlements, in fact they were tried to be concealed from the international cameras. Residents, seeing the kind of excessive expenditure on Olympics related infrastructure, hoped that those stadiums would not go abandoned like others from previous events (Malfini, 2016). Nonetheless, more than 12 of the 27 venues remain abandoned, in decay and disrepair, and are being vandalised. Rio De Janeiro is unable to repay its creditors, and the IOC has refused to help Brazil with its debt.

Furthermore, a political scandal unfolded surrounding the Olympics with investigations into many government officials regarding large bribes for Olympic construction projects. In the aftermath of the mega sporting event, the citizens are suffering a financial crisis, extremely poor sanitation in the favelas and public employees are not receiving due payments. The promise of a safe city for all has not been met, and the city has been left in disarray (Drehs and Lajolo, 2017). Corruption in the system combined with the lack of foresight in planning resulted in this financial disaster which plagued the economy of the nation and its general public, the government and private investors alike.

Risks undertaken by the government and private sector Anshuman Madan Malur, portfolio manager with DMI Finance, commented1 on the risks undertaken by the two primary sectors in infrastructure development. Governments keep changing over periods of 4-5 years, depending on the nation in consideration, and their perspective on infrastructure, therefore, remains short-term. The planning, development, building, maintenance and thereby recuperation of the investment in infrastructure done by the private sector, however, takes a much longer time. A delicate balance has to be maintained to ensure adequate risks are taken by both sectors.

The nature of infrastructure in a city (or in a specified region) is monopolistic. For example, there will be only one, or maximum two, airports in a city. But there will be a multitude of retail shops. Due to this reason, it is the government’s responsibility to ensure that the private entity with the lowest bid works on this project and subsequently charges the least toll from the

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During a virtual meeting with Anshuman Madan Malur, he gave insights on various risks that the government and the private sector comes across.

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public. This can be ensured through regulation, which is a fundamental component of infrastructure finance. Regulation depends on the risks apportioned between both the sectors.

Apportioning of risks between both sectors has developed and evolved over the years. At the time of the advent of public-private partnerships (PPPs) for infrastructure development, three areas of high risk were identified for the private sector with regards to highways and toll plazas.

First, aggregating land for a project - for example, there have been instances where a road was constructed in intermittent parts because the private entity was not able to aggregate the land in question that may have belonged to a farmer. The government then decided to take it upon themselves to aggregate land for infrastructure projects. Second, handling political pressure In the year 2012 Raj Thackeray urged people not to pay toll tax in Maharashtra which panicked the private investors (Raja, 2012). Third, traffic forecast risk - In a scenario where a private investor has already built a bridge and started taking toll tax based on some traffic forecast, but some political party builds another bridge nearby which is free of cost, this results in diversion of all the traffic. Therefore the traffic forecast calculation done by the private investor does not hold true and they are at risk of not generating the required returns from that investment (Madan Malur, 2020).

Seeing these risks that the private investors took, the government regulated and introduced an annuity to be paid to the private entities. The government steps in and prevents the private entities to make more profit than what was decided in a contract (which happened in the case of DND- Delhi Noida Delhi Flyway as is mentioned further in the paper), therefore it is their responsibility to also ensure that the entity does not depend only on toll to recuperate the cost.

The amount of cash-flow in these large-scale projects is huge, and the confidence of creditors is generally based on the credit ratings given to these debtors and their audited balance sheets. The investors depend on the opinions provided by the auditors before making decisions regarding their investments in other companies. Hence, the auditors play a crucial role in the system of debt-financing.

Auditors Auditors have to examine the financial transactions regularly to maintain the authenticity of the accounts, records, or books. The examination helps the auditors to give an opinion on whether the reports and documents are accurate or not and if they are free from all misstatements.

Misstatements are possible when financial statements are inappropriate due to swindling of numbers or genuine error.

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Further, auditing can be conducted via “Internal Auditors” and “External Auditors”2 (CFI). They are appointed by a company’s shareholders (“Appointment of Auditors as per Companies Act | Procedure”). As the auditor provides an objective and an independent opinion for assurance of an organization’s financial statements, it, in turn, brings several benefits to the shareholders, such as maintaining consistency, detecting frauds and finding errors in their processing. Other than this, because the nature of their report is unbiased, it even advises the people involved (the board of directors, shareholders, etc) in the company what necessary changes, precautions can be incorporated.

Moreover, adequate financial statements for any company would increase investors’ confidence in their investments. Whereas without proper regulations and standards in place, companies rely on strategies like “window-dressing”, in which a company misrepresents its financial statements to portray them as more profitable than they truly are. Thus, to review the authenticity and appropriateness of the financial position of a company, auditing is crucial.

The shareholders want the best for the company, and therefore select an auditor for their honest opinions on the financial statements of the company. In large companies like IL&FS, the investors also appoint a management to look after the company and its workings. There are instances of corruption where the auditors collude with the management and present dishonest opinions to the public. This is harmful to all the investors involved in the company. To gain the investor’s trust, credit rating agencies evaluate the risk associated with investment in the company based on the company’s credit history and the audit reports.

Credit Ratings and their Agencies Bonds released/managed by bond markets3 have to be evaluated to determine the risk of default on a bond issue, and this can be ensured by providing credit ratings. Before granting a financial instrument to an individual or a company or a firm, a possible credit risk analysis is done, which is determined by the creditworthiness and the credentials provided by the individual or the company. This analysis is what is defined as “Credit rating”. Credit Rating is determined after evaluating the liabilities and assets (ClearTax, 2020), and whether their fixed-income securities will be able to meet their obligations (Finney, 2019). Credit Rating Agencies (CRAs) are considered the gatekeepers which determine whether a company is worth 2

The company/firm employs internal auditors and they are deemed to ensure that internal financial controls are in place. On the other hand, external auditors are independent statutory auditors who examine the books and accounts and give a reasonable assurance of whether the financial statements are free from material misstatements.

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Bond markets are essentially financial/credit markets that deal with issues and trades related to debts. As stated by James Chin, former head of research at Gain Capital, “Governments typically issue bonds in order to raise capital to pay down debts or fund infrastructural improvements. Publicly-traded companies issue bonds when they need to finance business expansion projects or maintain ongoing operations.” (Chen, 2020)

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lending to or not and at what cost (Kaur, 2020). Each CRA has its rating scale. In the financial system, AAA-rated assets have been the most valuable asset because they are safest for investors and easiest to sell (i.e. with low yield and low risk). Out of the total 20 ratings ranging from AAA to D, up to BBB– is considered ‘Investment Grade’ ratings.

These ratings usually motivate the investors to constantly improve their fiscal plight to cope-up and improve their credit ratings and avail benefits. In India’s context, the lowest tier of federal structure is under the jurisdiction of Local Bodies (Rural Local Bodies-RLB and Urban Local Bodies-ULB), which play a crucial role to deliver the economic, social, and infrastructure services. In this case, ratings promised advantages on many fronts - transparency of ULB finances to both investors and citizens which increases accountability of ULB government as they would have to improvise their tactics with changing time, and ensure constant development and accomplishment of their functionality as it would in-turn help to maintain their credit ratings and thus issue of bonds. “Cities rated below BBB– need to undertake necessary interventions to improve their ratings for obtaining a positive response to the Municipal Bonds to be issued” (Yojana Magazine, 2019). Therefore, it led to the formation of an eternal loop which eventually contributed to India’s progress in modernizing its “municipal finance system” along with attracting private capital to finance urban infrastructure.

Further, the Government of India (GoI) set-up an expert group called the “Rakesh Mohan Committee” which worked closely with FIRE-D (the Indo-US Financial Institution Reform and Expansion- Debt project) to provide international experience on tax-free municipal bonds, which would in-turn help in the commercialization of Infrastructure Project. The municipal bonds introduced were an example of debt-financing. The tax-incentives received on these municipal bonds indeed acted as a national government subsidy where-in interest cost was substantially reduced. A mix of public and private funding was now possible in India to finance Urban Infrastructure. As there are multiple bodies involved in this process, certain regulatory bodies are set up by the government which have autonomous authority to supervise (B2B, 2017)and maintain stability in their respective sectors, by regulating the market, and arbitrating any disputes before moving the court.

Regulatory Bodies, Arbitration, and Judiciary Respective legislatures of most of the countries give rise to independent yet accountable “Regulatory bodies”. They are vested with functions and powers earlier enjoined by the governments or their agencies. These regulators draw parallel to the government in terms of the power that they possess, and with great power comes great responsibility. Therefore, they are responsible to a much greater degree for their actions and have much larger expectations to fulfil (Sundar et al.).

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The regulators relish certain judicial powers; their proceedings are often quasi-judicial and they have the status of a civil court. But certainly, they are not the judiciary as the judiciary is majorly responsible for the resolution of disputes and interpretations, defence, and application of the law in the name of the state (“Judiciary,” 2020). They usually deal in cases involving disputes among two parties, whereas the regulatory bodies are required to manage the interests of multiple groups and establish an equilibrium among them for the overall development of their respective sector. Examples of regulatory bodies are IRDA (Insurance Regulatory and Development Authority), RBI (Reserve Bank of India), and SEBI (Securities and Exchange Board of India). IRDA is for the insurance industry which looks after the well-being of policyholders. They also manage the growth of the insurance industry. RBI is the regulatory authority for the banking industry which reinforces rules to ensure financial stability. The regulatory body of the securities and commodity market in India is SEBI. SEBI looks after the interest of investors, they also manage and build the securities market4 in India.

Unlike the judiciary, the regulators must work within the constraints of specified regulatory objectives, which are made clear within the legislation itself and are obligated to the stated policy of the govt. The judicial process is retrospective whereas the regulatory process, charged with accountability for competence, evolution, and sector development, must be proactive and, where necessary, transcend current data to appear in the longer term (Sundar et al.).

Before moving the court for any disputes, both the parties often choose to resolve the conflict privately by appointing one or several arbitrators. These arbitrators are chosen consensually, and the case is heard in confidentiality. This process allows both the parties a neutral ground and an agreement is reached by the arbitrator that is appealing to both the parties. Arbitration is preferred as it avoids any penalty depositions, interrogations, and time consuming court hearings while providing a flexible solution in complete confidence. However, when arbitration does not resolve the dispute, the judiciary is consulted.

To understand the importance of the Judiciary in the infrastructure sector, let’s take the example of DND Flyway, which was, in fact, the very first instance where the public sector was seeking help from the private sector in India. DND flyway is a 9.2km, 8 lane road connecting Noida and East Delhi to South Delhi. In 1992, an MOU (Memorandum of Understanding) was signed between the UP government, Delhi administration, and IL&FS to build a toll bridge across the Yamuna. IL&FS made it a BOOT project (Build-Own-Operate-Transfer basis) and promoted Noida Toll Bridge Company Ltd (NTBCL) to take charge. With Rs 10 as the toll tax, DND started functioning in February 2001.

Securities market helps move resources from those who have idle resources to others who have productive needs for it. It provides channels for allocation of savings to investments and thereby separating these two activities.

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For the construction of DND, IL&FS and NTBCL were given a solitary charge of the flyway.

NTBCL was guaranteed a 20% profit as the reports in TOI suggested and was even allowed to fix the toll rates by itself and it was also permitted to collect for at least 30 years. It was in 2012 when The Federation of Noida Residents Welfare Associations (FONRWA) took the matter to the Judiciary, that was the Allahabad High Court, and sought an order to limit NTBCL from gathering toll on DND. The matter, however, didn’t receive justice at Allahabad High Court, and the plea was carried forward to the Supreme Court, which eventually looked into the matter. In 2015, NTBCL raised the toll from Rs. 25 to Rs. 28 for one-way car traffic, that induced large scale protests and even caught the attention of Akhilesh Yadav, former CM of UP, who ordered a probe to find out if it was still relevant to collect taxes on DND Flyway.

While presenting the case to Judiciary, Ranjit Saxena, the advocate of FONRWA, claimed that NTBCL had collected about Rs. 2000 crore in toll, and had profited more than Rs. 408 crore (90 crores more than the contract amount), but was still collecting toll from the public (TNN, 2016).

The plea of FONRWA finally received justice in 2016, when the court said, “The amended agreement between NTBCL and Noida permitting the company to collect toll till April 1, 2031, was arbitrary and violative of April 14 of the Constitution (right to equality) and involved excessive delegation and was thus unfair and unjust.”

Fig.1 - Diagram showing the relationship between the nodes in financial mechanisms of infrastructure projects

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Conflict of Interest In the above-mentioned financial processes of infrastructure development, it is understood that a major conflict of interest lies in the role of the private sector entity that is given the task of investing in and developing infrastructure. Their participation reduces the load on the government, but their main interest lies in making profits. To that end, they risk an asset-liability mismatch for better profits, which is not prudent finance. Nonetheless, the private sector’s participation is crucial for infrastructure development for governments lack the funds and the expertise for the same.

A major conflict of interest also lies in the appointing of credit rating agencies. In the “Issuer Pays” business model, the debtor appoints the agency to provide their securities with a rating.

The CRAs (credit rating agencies) are thereby incentivized to over-rate these securities in order to retain their clientele in subsequent years. Another conflict is that the CRAs rate the securities based on the information willingly provided by the debtor. They have no means of verifying this information and any concealed fraudulence is automatically over-rated (Rafailov, 2011).

The example of Lehman brothers case shows possible conflict of interest between investment banks and other players in the mechanism.

Subprime Mortgage Crisis The Lehman Brothers Crisis is the economic crisis that shook the world when uncreditworthy parties defaulted on low-rated loans they had taken against their house mortgage. This impending adversity festered for almost 10 years before it came to light and consumed Lehman Brothers (the 4th largest investment bank then) in its wake.

In the early 2000s, the real estate market was on fire fueled by cheap credit and low-interest rates. The investors seeking better returns found an opportunity to create new investments.

They started investing in mortgage-backed securities and CDOs (collateralized debt obligations). These CDOs are numerous small mortgages and loans packaged as one product that combines mortgages of different risk categories (AAAs, Bs, and unrated). Small banks sell these mortgages to large investment companies in the form of CDOs, thereby transferring the risk of default from banks to the investors. Investment companies bought a great many of these CDOs as they were sold as AAA-rated and they could sell the mortgaged property in case of default. The excess cash available to the banks allowed them to make new loans, which meant easy access to mortgages for home buyers. Eventually, banks started making subprime mortgages to borrowers with impaired credit history as it would not affect them directly if they sold these mortgages as CDOs. As a result, everyone could buy his/her dream house, and as real estate prices were consistently and steadily increasing since forever it was a great investment.

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Fig.-Diagram showing the process linked with CDOs

This process was profitable to everyone from home buyers, banks, to investment banks until these unreliable subprime mortgages started defaulting and investment banks began putting the mortgaged properties on the market. Increasing defaults led to excessive supply in the housing market, and the bubble finally burst with real estate prices plummeting more than ever.

Since a large portion of investments by Lehman Brothers were in CDOs, they posted multiple losses and share prices dropped.

By 2007, subprime mortgage brokers started becoming bankrupt and real estate funds began to fail. In 2008, U.S. investment bank Lehman Brothers collapsed unleashing a global financial crisis. It is known to be the biggest bankruptcy in American history leading to the worst economic crisis since the 1930's “Great Depression”.

The problem of making subprime mortgages remained unnoticed from the early 2000s until the bubble finally burst in 2008 and it created a domino effect that took down not only the world’s largest economy but also many other economies. This unchecked growth of the problem could be blamed on the Federal Bank for lenient regulations, but the complex structure of these organizations made it difficult for corporate boards, regulatory authorities, and even the auditors to understand the problem. Likewise is the case of IL&FS and its hundreds of subsidiaries (Lioudis, 2019).

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One of Lehman’s closest competitors, Bear Stearns, was the first to collapse which was saved from bankruptcy by sale to J.P.Morgan Chase (backed by the federal government). Next to fall was Lehman Brothers in the aftermath of Bear Stearns’ sudden collapse. It’s reliance on short term funding deals called repurchase agreements or “repos” to raise money for business made it vulnerable to a crisis in market and investor confidence (“Lehman Brothers declares bankruptcy,” 2020). An announcement was made on September 10, 2008, showing that the firm is expecting a “toxic” asset of $5.6 billion in write-up and a loss of $3.93 billion. After this Lehman Brothers was threatened by a major rating agency Moody to downgrade it’s debt ratings. Despite concerns about the consequences that Lehman Brothers collapse would bring, the government refused to bail out yet another investment bank. The government’s decision to not bail out Lehman Brothers and let it fall was questioned by many (“Lehman Brothers declares bankruptcy,” 2020).

Lehman Brothers had employed Ernst & Young as their independent auditor to review its financial statements, for a long time before its demise. EY was supposed to try to detect fraud and communicate certain issues to Lehman’s Board audit committee. But after the bankruptcy of Lehman Brothers was filed, EY’s questionable accounting with regard to unorthodox financing transactions was discovered. It used ‘Repo 105’ to make the results better than they actually were. EY also knew about Lehman’s impaired liquidity pool. But when questioned by the authority, EY said that it hadn’t done anything wrong (Wiggins et al., 2014). However, Anton R. Valukas, the Lehman bankruptcy examiner, concluded that “EY had not fulfilled its duties and that probable claims existed against EY for malpractice”.

The credit rating agencies (CRAs) had a central role in the development of this complex crisis network. The transformation of a subprime mortgage from low-rated into AAA, allowed everyone to enter the subprime mortgage market which seemed very profitable at that time. An AAA-rated corporate bond had never been downgraded lower than A by Moody’s. However, an AAA-rated investment had become susceptible to failure. This led to a huge loss of faith in rating agencies.

Therefore, The adequacy of auditors and credit rating agencies is crucial in the functioning of financial debt markets.

“Hopes of a sale to another bank fell short as well: One prospective buyer, Bank of America, decided to buy Merrill Lynch instead, while British regulators blocked a last-ditch deal to sell Lehman to Barclays of London. Out of options, Lehman Brothers declared bankruptcy early on the morning of September 15. The firm declared $639 billion in assets and $613 billion in debts, making it the largest bankruptcy filing in U.S. history” (“Lehman Brothers declares bankruptcy,” 2020).

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II. The case of IL&FS ______________________________________________________________________________ For infrastructure development, the private sector has been seen to take responsibility to invest in certain projects, which reduces the load on the public sector and simultaneously, desired results are obtained. However, while such privatization has experienced many triumphs, success is not guaranteed at all times. That is the story of IL&FS.

Overview Infrastructure Leasing & Financial Services (IL&FS) Limited was one of India's leading infrastructure development and finance companies (IL&FS - Who We Are). It helped in catalyzing the process of development of infrastructure in our country. It was established in 1987 as an NBFC with the main shareholders being Housing Development Finance Corporation (HDFC), Unit Trust of India (UTI) and Central Bank of India (CBI). Over the years, many other parties became shareholders of IL&FS. As of 2018, major shares were held by HDFC, Life Insurance Corporation (LIC), State Bank of India (SBI), CBI, a Japanese company named Orix, and the Abu Dhabi Investment Authority (ADIA).

Fig.- Major shareholders of IL&FS

IL&FS is categorized as a Non-Banking Financial Company (NBFC) or ‘shadow bank’ and is acknowledged as the pioneer of Public-Private Partnerships (PPP) in India. IL&FS collaborated for the very first PPP Project in India, dating back to 1992, where they developed and financed the construction of the Delhi-Noida Toll Bridge.

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An NBFC as described by RBI (Reserve Bank of India) is, “A company registered under the Companies Act, 1956 engaged in the business of loans and advances, acquisition of shares/ stocks/ bonds/ debentures/ securities issued by Government or local authority or other marketable securities of a like nature, leasing, hire-purchase, insurance business, chit business but does not include any institution whose principal business is that of agriculture activity, industrial activity, purchase or sale of any goods (other than securities) or providing any services and sale/purchase/construction of an immovable property” (Reserve Bank of India Frequently Asked Questions).

Furthermore, the process of high-yield lending undertaken by the NBFCs outside the regular banking sector and financial intermediation activities is referred to as shadow banking.In the case of developing economies like that of India, certain sectors have difficulty in accessing the credits, and are thus helped by Shadow banks which help them in facilitating credit. (Reserve Bank of India - Frequently Asked Questions).

However, in recent times there has been a decline in the commerce of India's shadow banks.

Awful numbers are being showcased by sectors that are dependent on credits from NBFCs (Sharma, 2019). Insurance services are dwindling and real estate is troubled. Because of the liquidity crisis of IL&FS, lending to real estate developers by NBFCs fell by almost half (“IL&FS default impact,” 2019).

Company’s mismanaged borrowings in the past brought the whole company to its knees.

IL&FS financial services fell short of cash and defaulted on several of its obligations. Even as new infrastructure projects dried up, IL&FS' running construction projects faced cost overruns amid delays in “land acquisition” and approvals (“WHAT IS IL&FS CRISIS”). Due to the Land Acquisition Act, the company was supposed to pay compensation, which was not in the favour of IL&FS. The act has enforced various changes to the process of land acquisition, making the process more time-consuming and even expensive. IL&FS, being a private entity undertaking distinct infrastructure projects in the country, was bound to face repercussions of this law in an adverse manner.

In the article Infrastructure in India: Challenges and the Way Ahead, the author- Pradeep Agrawal, Professor and Head at the Institute of Economic Growth, Delhi comments, “Land acquisition for infrastructure and industrial projects has been made too cumbersome by the new law of 2013; it needs to be revised. Regulatory and environmental clearances also delay infrastructure projects; these need better governance.” (Agrawal, 2015) In 2013, unrest began to stir in the company. The company had bid for too many projects, stretching out their balance sheet, moreover, costs of projects escalated due to land prices.

The immediate relief measures that were sought for were raising Rs. 4500 crore in a share sale and the company took loans worth Rs. 3000 crore from SBI and LIC (two of its shareholders).

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As the situation worsened, the only way to salvage was to put up assets for sale and avoid taking on new projects (Rangan and Kalesh, 2018).

Fig.- Timeline of events with IL&FS since the establishment

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IL&FS is a private sector entity, but around 40% of its shares are held by public sector undertakings. Hence, the government had to ensure solvency in order to maintain financial stability in the country. In an attempt to salvage the sinking ship of IL&FS, the government petitioned to change the managerial board of the company, which was ratified by the National Company Law Tribunal (NCLT). The existing management had lost its credibility due to the continued payment of dividends and managerial pay-outs in spite of an impending liquidity crunch. In 2018, a new board was constituted as the old one failed to discharge its duties. The government also appointed transaction advisors - Arpwood Capital & JM Financial, and Alvarez & Marsal (“WHAT IS IL&FS CRISIS”) to maintain strict liquidity control, manage stakeholders as well as develop a resolution plan. Even though these measures were being taken, IL&FS was far from being rescued.

Malpractices within subsidiaries of IL&FS Ltd. propelled the collapse. IL&FS Financial Service (IFIN) is one such example where the company and its auditors colluded to deceit and dishonesty. IFIN is the lending arm of IL&FS ltd., and it extended loans to companies without adequate securities, negative net worth, and for the purpose of evergreening of loans. The auditors of IFIN were Deloitte (2008-2018) and BSR Associates, a unit of KPMG, for FY17-18.

This abusive lending wasn’t enquired by the auditors. The government sought a 5-year ban on these auditing companies. The Serious Fraud Investigation Office was involved to investigate 30 entities related to IL&FS group, and a new auditor, Grant Thorton was appointed to audit the books.

The shadow banker operated over hundreds of subsidiaries and as of 2019, it was sitting over a debt of Rs. 94000 crore of this, almost Rs 60,000 crore of debt is at the project level, including water, road and power projects (Rangan and Kalesh, 2018) and the prime reason for the majority of these debts is an asset-liability mismatch.

Asset Liability Mismatch In the case of IL&FS it continued to borrow short-term loans to finance long-term projects, but the long-term projects could not generate revenues to repay the loan in time (Chanda, 2019).

The debt-to-equity ratio indicates the proportion in which financing is provided in the company.

It is crucial in determining whether or not banks will lend to the companies. The preferred debt-to-equity ratio is generally 2.0 or less, which portrays a healthy balance of finances in the company. As is indicated in the graph below, this was not the case with IL&FS:

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Fig- Increase in debt-to-equity ratio in the case of IL&FS (from 2015-2018) Source: (Rakheja, 2019)

This graph indicates that the debt-to-equity ratio increased from 9.47 to 16.78 in the years 2015-2018. Inflation in short-term loans from 22.9% to 28.3% in this period worsened the asset-liability mismatch - increasing short-term loans for long-term projects.

Rubbing salt to the wounds was the alarming “current ratio”- which is defined by Will Kenton as, “the ratio that measures a company’s ability to pay short-term obligations or those due within one year.” In other words, it is the ratio of the current assets of the company to the current liabilities of the company. In the case of IL&FS, this current ratio was less than 1, which was a clear indication that the capital in hand with IL&FS was insufficient to meet its short-term obligations if they were all due at the same time, but still, they opted for it.

The 3 credit rating agencies of IL&FS were ICRA (Investment Information and Credit Rating Agency), CARE (Credit Analysis & Research Ltd), and India Ratings and Research Pvt Ltd. They gave ratings to the NCDs (Non- convertible debentures), CPs (Commercial paper), and ICDs (Inter-corporate deposits); in which the NCD was given the highest ratings. This continued till August 2018. But from August 17 to September 17, the rating got downgraded which brought a serious financial loss to investors.

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On Aug 17- CARE changed the rating of NCDs to AA+ from AAA. On Aug 24- India Rating changed the NCDs rating to AA from AAA. On Sept 10- ICRA and CARE downgraded the IL&FS NCDs to BB from AA+.

On Sept 17- ICRA downgraded the ratings of IL&FS NCDs and CPs to the default category (Tambe, 2019). These CRAs were only charged a meagre fine for delaying the down-rating of these securities. Had they updated the ratings in time, the effects of the defaults would not have been so severe (Kaur, 2020).

Impact of the crisis MSMEs5 (Micro, Small and Medium Enterprises) depend greatly on NBFCs for loans and credit to advance their businesses. NBFCs become the preferred choice over banks for loans, especially for smaller businesses, because of less stringent eligibility criteria, easier approval for loans, minimum paperwork, competitive interest rates, and the provision of loans even with less credit score (which is highly likely for the riskier sectors like MSME)(“Banks or NBFC,” 2019). However, less stringent norms have led to excessive and abusive lending - as was seen in the case of IL&FS. Regulatory bodies should enforce a system with adequate regulations that still facilitates finance for less creditworthy bodies.

Some major conflicts of interest were observed in both the major crises studied in this paper the subprime mortgage crisis of 2008 and the IL&FS crisis of 2018. These ratings become the basis of investment decisions by everyone from the common man to the biggest investment bank. This system does not always work in the interest of the market and a more robust system needs to be envisioned, which will provide honest information and will also warn investors of impending doom well within time.

After the financial crisis which shook global markets in 2008, India in 2018 has been massively hit by the IL&FS crisis, which has affected the stock market, debt market, equity market, and created a liquidity crunch. NBFCs and HFCs (Housing Finance Companies), domestic debt markets, and banks have become vulnerable due to the IL&FS crisis (Chanda, 2019). The major sectors affected by the crisis are as follows: Automobile Sector - The auto sector makes up 49% of India’s manufacturing GDP but due to NBFCs’ reduced lending, car sales dropped for 8 straight months till June 2019 and in July 2019, sales dropped as much as 30% (Reuters, 2019).

Real Estate Sector - NBFCs had emerged as a preferred source of financing for real estate developers and home buyers. But after the IL&FS crisis in Sept 2018, lending by NBFC was 5

MSMEs are either manufacturing or service enterprises. They are classified based on two aspects -

investment in plant and machinery, and annual turnover (Vasal, 2020).

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halved to 27000crore in FY '19, and due to the liquidity crunch thereafter, the delivery timelines got skewed. NBFCs also advanced home loans easily, which diminished post the defaults (Press Trust of India, 2019). This led to reduced demand from the consumers.

NBFC Sector - The crisis of IL&FS has negatively impacted the NBFC sector. RBI has decided to regulate NBFCs. To that end they have introduced regulations such as liquidity coverage ratios and consolidation schemes that bind NBFCs. Investors are also hesitant in investing in NBFCs (PTI, 2019b).“However, the prolonged liquidity distress will significantly erode the NBFIs' credit standing, and prove negative for the broader economy and structured finance sector,” Moody’s said in a statement (Lele, 2018).

Banking Sector - The IL&FS crisis affected the banking sector in positive and negative ways.

The liquidity crunch pushed corporate borrowers towards banks taking them away from bond markets. Bond markets turned risky in 2018. And even the bank loans were cheaper than bonds in some cases (Ghosh, 2018). Therefore, more people turned back to banks for loans.

However, due to defaults in repayment by NBFCs, the banking sector was in distress due to non-performing assets.

Auditing Sector - Tough rules for auditing firms, ban on non-auditing firms, and restructuring the advising companies (Srivastava, 2019), limiting its revenue generation by the corporate affairs ministry Indian Economy - NBFCs are ‘material providers of credit for economy’. Therefore, slowdown in credit growth provided by NBFCs will hamper overall consumption and economic growth.

IL&FS being an NBFC, RBI did not exercise as much regulation over its operations as in the case of traditional banks.

Credit Rating Agencies - The lack of transparency in this sector has been highlighted by the crisis. The government now plans to tighten its grip over credit rating agencies ICRA, India Ratings & Research and CARE (Mishra, 2019).

Investors -Most affected by this crisis are the Investors that include Individuals, Mutual Funds, Companies and Banks that offered loans as "Inter-Corporate deposits6". If the Liquidity crisis extends, consumption will go down even more, weakening the growth further. The requirement is to restore investors' confidence that is troubled about the grasp on other shadow banks, promoting a rise in volatility among financial stocks (Bakshi, 2019).

The collapse of an NBFC mammoth (IL&FS) unnerved other investors like Larsen and Toubro, Reliance, and some other mutual funds – who have lowered their assets in such partnerships.

This is a clear indication of the lack of trust and confidence of companies in partnerships and Inter Corporate Deposits (ICD) - These are collateralized borrowings that corporates get from other private companies registered under the Companies Act of 1956. Therefore, these are usually at a higher rate of interest.

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strategies like shadow banking, which has, in turn, increased the strain on public and private sector companies (Shukla and Sinha, 2019).

One of the major projects that was affected by the crisis was the flagship project by Gujarat government that was also a part of the ambitious political campaign of creating world class infrastructure and putting Gujarat on the world map, under the name of “Gujarat model” of development - GIFT city.

GIFT city GIFT City (Gujarat International Finance Tec-City) was conceptualised as a project to create an international financial hub in India at par with New York, London, Tokyo, and Shanghai. GIFT City was finally proposed in 2007 as a smart city which will house the country’s first International Financial Services Centre (IFSC), which includes a multi-services Special Economic Zone (SEZ), as a joint venture between IL&FS (Infrastructure Leasing and Financial Services) and GUDC (Gujarat Urban Development Corporation), which is a government undertaking (Dalal, 2018).

In spite of criticism that a project of such financial and economic importance be located near Mumbai, the financial capital of India, where substantial infrastructure in terms of transport and connectivity, housing, and energy is readily available, GIFT city sought to create a new financial centre in Gandhinagar where the project had to start from scratch as there was no sizable infrastructure readily available. This meant participation from the private sector was a given.

The contract for this development project was given to Fairwood Group, and eventually to IL&FS. It later came to light, when a PIL (Public Interest Litigation) was filed in the Gujarat high court by the former independent director of GIFT city Mr DC Anjaria citing irregularities in the transactions and processes with IL&FS, that these contracts were given without any competitive bidding process. Both these contracts were in violation of the Gujarat Infrastructure Development Act of 1999 and were given without due process (Dalal and Sapkale, 2018).

Despite efforts by the Narendra Modi’s government over the past years to offer tax and regulatory concessions GIFT’s future is uncertain. In 2018, the government of Gujarat announced its plans to buy out IL&FS’s 50% stake in the GIFT city to guarantee there were no postponements in executing the project further.

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Conclusion ______________________________________________________________________________

Infrastructure is crucial in determining the economic growth of the nation. Since the last decade of the 20th century, plenty of infrastructure projects in India have been financed with a mix of public and private funding, which has improved the quality and timely completion of the projects. Despite the active involvement of both the sectors, India is still struggling to maintain pace with other fast-moving economies like China or other emerging economies. Developed nations showcase a stark contrast to India in terms of physical and social infrastructure which have become a source of inspiration for our country (Agrawal, 2015).

The recent events of the IL&FS crisis have highlighted the structural vulnerabilities in the financial mechanisms of urban development through debt-financing. Some of the major conflicts of interest identified above may lead to distressing endings for a particular investment.

These troublesome events lead to a liquidity crunch which affects investors who are due repayment as well as debtors who depend on loans to continue working. Investors advance their money as loans after analysing the risks attached to the investment because they want to minimise the risk of defaults for debt repayment.

Debt financing as a method of financing is used all over the world for a multitude of business ventures. Deficit financing has become the basis of urban development all over the world.

David Graeber in his book Debt: The First 5000 Years (published in 2011) talks about perceived morality that the concept of debt is regarded in, in the eyes of the general public - when people assume that repaying loans is one’s obligation, that implies there is no degree of risk on the part of the lender: “Isn't paying one's debts what morality is supposed to be all about? Giving people what is due them. Accepting one's responsibilities. Fulfilling one's obligations to others, just as one would expect them to fulfill their obligations to you (Graeber, 2011, p. 4).”

However, this is not the system debts are based on - it is based on the assumption that the creditor may not be able to retrieve the money. The possibility that a debtor may not be able to reimburse the debt makes the entire system more complicated and realistic. “If a bank were guaranteed to get its money back, plus interest, no matter what it did, the whole system wouldn't work (Graeber, 2011, p. 3).” Financial institutions are meant to advance money towards profitable investments or transactions. Bankruptcy laws all over the world allow debtors a fresh start by forgiving their debts when it is established that they are not in a position to repay their creditors. In such a situation, creditors are given the opportunity to retrieve their money by liquifying the debtors’ assets, which may not generally lead to a full 24

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recovery (Tuovila, 2020). This means that creditors are not ensured to get their money back.

This introduces the need for risk assessment, credit ratings, auditors - all to assess the creditworthiness of the parties involved. The system continues to become complicated as the number of participants in the mechanism increases.

Even though the nodes of credit rating agencies and auditors are present to make the system more robust, debt financing has proved to be not a very prudent financing method. Notable conflicts of interest within the system, which may or may not have been identified on paper, have been identified in the mechanism in real life: ●

Private sector participation is widely accepted for its contribution to finance and relevant expertise in the field of infrastructure. These entities undertake projects involving service, development, operations and maintenance of the assets. However, there are disadvantages to their participation in infrastructure development - projects which affect the lives of multitudes of people. The private sector seeks to make profits in every project it gets involved in. This was witnessed in the case of the DND flyway, where NTBCL continued to collect toll tax even after making the desired profits as per the contract.

Another reasonable argument is that privatization of basic necessities like water might jeopardize the basic right to drinking water. For example, due to the desire of profits, the privatisation of water in Cochabamba, Bolivia, resulted in the infamous ‘water war of Bolivia’. Some of the examples closer to home are the Borai Industrial Estate’s Water Supply project on the Sheonath river in Chhattisgarh and Kannada Ganga Project in Karnataka (CB, 2010).

We understand the importance of private sector participation in urban development projects due to insufficient funds with the government. However, the differences in aspirations lead to adverse effects on the economy and the common man.

●

Auditors are involved to provide honest opinions about a company’s financial position.

The system is such that auditors are appointed by the shareholders of the company, who naturally want the best for the company they have invested in. This ensures that the external auditors thus appointed are not on the ‘issuer pays’ business model, thereby reducing chances of collusion. However, in large scale companies like IL&FS, the management appointed to oversee the modus operandi and performance of the company may collude with the auditors on a personal level. This corruption is generally not accounted for on paper, but it occurs in real life - as is evident in the case of IL&FS.

●

Credit rating agencies, based on whose ratings investors decide whether or not they want to delve into certain investments, follow the ‘issuer pays’ business model. There are steep chances of collusion in such a situation where a company will pay hefty 25

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amounts to paint a pretty picture of themselves and their securities. This is also witnessed in the case of IL&FS and the Subprime Mortgage Crisis of 2008.

NBFCs are crucial for the nation because they are the main source of supply of credit for the economy. However, they tend to create asset-liability mismatches as part of their financial model which is not prudent financing. Any effect on NBFCs is resonated in the broader economy of the nation. After the IL&FS crisis, RBI is attempting to regulate NBFCs to mitigate these problems (Lele, 2018).

Debt financing as a financial mechanism is in practice all over the world. It is an essential system to facilitate the funding of many projects - large or small. However, some discrepancies in this system have been identified, some of which are evident on paper as well. Attempting to resolve these conflicts will go a long way in improving the major financing system the entire world economy depends upon. Proper planning, stringent regulations, and increased transparency in the development of urban infrastructure projects will also help India achieve its ambitions in terms of economic growth, and providing for the needs of its quickly expanding population in a sustainable manner.

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Acknowledgments ______________________________________________________________________________ We thank Dr. Leon A. Morenas for his constant support and motivation. His guidance has come a long way for us to write this research paper. We would also like to thank all faculty members and our colleagues for their continued support.

We express our sincere gratitude for Mr. Anshuman Madan Malur, for his insight and expertise has greatly assisted with the research.

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