Context:

• Non-banking finance companies (NBFCs) are facing a liquidity squeeze, leading to an offer last week by State Bank of India to bail out the NBFCs by buying good quality assets from them.
• The current crisis is a fallout of defaults by Infrastructure Leasing & Financial Services (IL&FS) beginning September 2018; the short-term debt instrument that it defaulted on is called Commercial Paper.

What is it?

• Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. CPs are short-term instruments and the maturity period varies from seven days to up to one year. The instrument was introduced in 1990 to enable highly rated corporate borrowers to diversify their sources of short-term borrowings, and also to provide an additional instrument to investors. CPs can be issued by corporates, primary dealers, and financial institutions. Eligible participants should have a minimum credit rating of A-2 at the time of the issuance of the CP. Banking companies, mutual funds, other corporate bodies, NRIs, individuals and foreign institutional investors (FIIs) can subscribe to CPs; they are also traded in the secondary market.

Why should you know?

• Beginning September 2018, IL&FS, a giant government-owned conglomerate that has executed, or is in the process of executing, some of the largest infrastructure projects in the country, started to default on its commercial papers.
• Following the defaults, rating agencies ICRA, India Ratings, and CARE abruptly downgraded IL&FS and its subsidiary from high investment grade (AA plus and A1 plus) to junk status, indicating actual or imminent default.
• This led to panic in the debt market, and a drying up of liquidity in the system — and NBFCs and housing finance companies (HFCs) started to find it tough to carry out their normal businesses.
• Many corporates, mutual funds, and insurance companies have invested in CPs and non-convertible debentures (NCDs) of the IL&FS Group, and there is fear that in the wake of the default, their funds could be locked in IL&FS debt instruments.
• With the liquidity shortage close to Rs 1 lakh crore in the system, fears have intensified that the funding cost for NBFCs will zoom, and result in a sharp deterioration of their margins.
• Default by a big corporation like IL&FS is likely to keep away potential investors in debt instruments of HFCs and NBFCs. Sharp losses in NBFC stocks have triggered a vicious cycle — losses in leveraged positions are leading to selling in other stocks to cover those losses, which is in turn fuelling further losses in the market.

What’s the reason?

• At the heart of the problem lies the issue of raising funds for long-term infrastructure projects. While IL&FS needed funds for 10-15 years for execution of long-gestation projects, it usually raised funds for 8-10 years, and then got the project refinanced.
• However, some three years back, when banks stopped refinancing and funding infrastructure projects, IL&FS was caught in a situation where it needed funds on an immediate basis in order to complete projects that were in various stages of execution. It was then that IL&FS started looking at other sources of finance, including CP and debenture issuances.
• This led to IL&FS being caught in a situation of a big asset-liability mismatch, as it was using short-term funding instruments to finance long-term infrastructure projects. With a huge requirement of funds but no availability, IL&FS reached a situation in which it could no longer honour its obligations, and started defaulting on commercial papers.

Source:IE