IL&FS and the La-La Land that is Indian Credit Rating

The IL&FS saga has many interesting sub-plots, not the least of which is tied to the exploits of rating agencies.

I remember a cartoon from the front-page of a prominent Bengali newspaper from sometime in the late 1960s. It was a delightful collage of four tiny frames that, together, told a neat story.

A dhoti-clad, paan-chewing, balding gentleman is leaving for work in the morning, an umbrella tucked under his arm. He starts, but remembers something and comes back home. “What is it?”, the wife asks. “Please look up today’s weather forecast in the papers, will you?” the man says.

The lady looks, and then announces that heavy rains were on the cards. Relieved, the husband grins and hands the umbrella back to the wife, saying, “Well then, I don’t need this today, for sure.”

A variant of the story, this time from England, finds a weatherman, new to his post, grumbling that his job has been made very difficult. Why? Because the only window in his new office looks out on another tall building that cuts off his view to the sky. How can he read the weather if he cannot look at the sky, pray?

Our Met office has made giant strides since the hapless 1960s, and today the weatherman’s attention is taken up with so many sophisticated devices and gadgets that he rarely finds time to look up at the sky. The weather forecasts are nearly as accurate as they were back then, though. The difference is, today we trust the reports, maybe because we are aware of the heavy artillery the weatherman so cheerfully deploys today, unlike his antediluvian brother who only had his battered weathercock to lean upon. Also, we have perhaps successfully shed the irreverent scepticism of the 1960s and more readily trust all symbols of power and authority now.

It is this trust, this faith, that keeps our financial systems well-oiled and functional. Faith in the markets and its many players, in the countless experts on TV panels who solemnly dispense management-school jargon that means just what we want to hear, in the credit rating agencies that are supposed to point to the risks (or their absence) underlying an investment decision.

Financial management, indeed, is more like theology today than it has ever been before. Faith empowers you, and without it, you are a goner. The recent IL&FS imbroglio is a case in point.

It seems that the institutional risk rating/measurement eco-system in India replicates our 1960s Met department in more ways than one. Our rating agencies have not learnt how to make use of the complex analytical tools adorning their plush downtown offices in Mumbai or Delhi. Equally, reading the sky with the naked eye is well beneath their professional dignity.

Happily cocooned in what many believe to be the sophistry of their rating ‘advisories’ and ‘rationales’, they very reluctantly put out the red flag over a client’s finances – after all, it is the same client who foots their rating bill – and do so well after the horse has bolted from the stable.

Till August 2018, two of India’s top-drawer credit rating companies – namely, ICRA and CARE – continued to award high credit ratings (implying low risk factors) to both the long  as well as the short-term borrowings of the country’s non-bank financial behemoth – the IL&FS Limited and its numerous appendages.

Also read: With NCLT Approval, Indian Govt Seizes Control of Debt-Laden IL&FS

A third rater, India Rating & Research Pvt Ltd, had downgraded a group company (ITNL)’s long-term borrowings to a sub-investment grade in July, but continued to accord good risk grades to ITNL’s short-term paper.

Most importantly, India Rating affirmed its excellent long-term credit rating for IL&FS, the parent company, even though ITNL had already defaulted on its repayment/redemption obligations under a Commercial Paper tranche even as  IL&FS had simply looked on.

What these three high-profile credit raters together ensured was that the IL&FS group alone managed to corner over 2% of all Commercial Paper, 1% of all Corporate Debentures and nearly 1% of all banking system loans outstanding at the whole-country level, the group’s aggregate borrowings touching a phenomenal $13 billion (a little under Rs one lakh crore!).

In the financial year 2017-18, these borrowings rose steeply, by over 44% over the FY 2014-15 levels.

This, despite the fact that, on a consolidated basis, the group had been losing money for at least three consecutive years, the aggregate loss in FY 2017-18 working out to nearly Rs 21 billion. As though this was not enough, the consolidated group net worth (aggregating share capital and accumulated reserves) at March 31, 2018 – adjusted for intangible assets, preference share capital, cumulative redeemable debentures and revaluation reserves – boggled the mind at a negative 230 billion. But the rating companies were not unduly worried.

ICRA and CARE were finally impelled to downgrade IL&FS’s ratings only on September 17, after multiple credit defaults, and only when it was clear as day that the group had nowhere to go. Overnight, the darling of India’s debt markets became a pariah. The theatrics of the downgrade were quite as obnoxious as the earlier euphoria about “[its] experienced senior management team and its significant track-record of operations in the infrastructure domain”, as a March, 2018 ICRA advisory had noted even as it recognised that IL&FS was “very highly leveraged” (its debt to equity ratio exceeding 13:1).

From ‘AAA’ or ‘AA’ ratings (the two  highest possible grades on the rating scale) the company was consigned to the lowest of the ‘junk’ grades, a ‘D’. ICRA boasts  an excellent lineage, that of the US giant Moody’s, while India Rating, which proudly describes itself as “the most respected company in the debt rating space in India”, derive from another giant, Fitch. Not far behind, CARE supposedly pools the expertise of some of India’s top lenders/ fund managers – Canara Bank, IDBI and UTI. None of them read the disaster as it was happening around them, much less anticipated it, which, incidentally, is their precise job: putting investors wise to the real health and business outlook of the investee company. They failed to see the storm clouds, neglected to measure the rainfall, and when all hell broke loose, threw up their hands and ‘forecast’ turbulent weather even as investors staggered from the losses they had sustained and were still booking. It was a scandal of humongous proportions. Effectively, the rating companies actively misled lenders and investors who put their money in IL&FS in the belief that IL&FS’ credit ratings were a reliable index of their present and future health.

A screen displays Moody’s ticker information as traders work on the floor of the New York Stock Exchange January 20, 2015. Reuters/Brendan McDermid

The raters were even blind to a signal that was there for everyone to see. In July 2018, after the first defaults were registered and the market was abuzz with news about more severe dislocations, Ravi Parthasarathy, the group’s non-executive chairman, stepped down citing ‘health reasons’. A year earlier, in October 2017, Parthasarathy had relinquished his post as Chairman-cum-Managing Director, but anybody who knew anything about IL&FS never had any doubts whatever about who called all the shots at the group even after that, regardless of who was officially in the saddle. (Indeed, IL&FS was synonymous with Parthasarathy for decades.)  It was a strategic retreat before the chickens came home to roost. Significantly, Parthsarathy took home in FY 2017-18 total emoluments of Rs 205 million, a near-100% raise over FY 2016-17.

Before we turn to the quandary of Indian credit ratings, it would be instructive to remember the Enron fiasco exactly 17 years ago, for there are striking similarities between Enron and IL&FS – though it is not our case yet that IL&FS is a fraud a la the US energy trader. The American dream was not fastened with greater faith on any other single entity than this enigmatic conglomerate that, over a mere four-year period from 1996, had ramped up revenues by over 750% and seemed to have succeeded in standing every market axiom on its head. In 2000, the year prior to its demise, ENRON saw its stock prices rise by over 87%, while the market index actually fell by 10%!

Also read: IL&FS Wins Shareholders’ Approval for Restructuring Plan

Fortune, in its survey of ‘Most Admired Companies’, rated ENRON ‘the most innovative large corporation in America’ for six straight years. Both Moody’s and Fitch, the parent companies respectively of ICRA and India Rating, consistently awarded to ENRON’s several debt offerings the best possible risk ratings. Here was a corporation that really seemed to have the Midas touch, minting billions of dollars out of thin air even as all America watch in rapt admiration.

Then, on August, 14, 2001, Enron’s CEO Jeffrey Schilling resigned from his post for ‘personal reasons’. Soon enough, there was deluge. The company’s shares, which had peaked in mid-2000 at $90.75, went into free fall, quoting at only a few cents by November, 2001. Gigantic accounting manipulation and every kind of statistical and accounting jugglery began coming to light.

Analysts, till then overawed by Enron’s massive public stature and thwarted by its powerful muscle-flexing, started commenting on how “it is really hard to determine where (ENRON) are making money in a given quarter and where they are losing money”. On September 9, the New York Times observed that “something (was) rotten with the state of ENRON”. An SEC investigation was initiated by regulators into the company’s outrageously opaque accounting practices, the management admitted to the necessity of ‘restating’ the company’s financial results for the years 1997 to 2000 (which revealed hugely-overstated revenues and earnings), and numerous instances of the most glaring conflict of interest began to be discovered in senior management actions and compensation packages. Incredibly, though, the credit rating companies persisted with their high grades for Enron, downgrading Enron to ‘junk’ only 4 days before the company filed for Chapter 11 bankruptcy, for assets worth $64 billion, on December 2. The company’s 20,000 employees lost most of their pension funds – their jobs as well – and the stock meltdown reduced nearly two million investors to penury. In another bizarre development, Arthur Andersen, one of the five largest audit practices in the world and ENRON’s favourite auditors, had to fold up its business as they were prosecuted for complicity with the company management.

We may point out that unless there is a bail-out for IL&FS here in India, the group has few options other than knocking at the door of the Insolvency and Bankruptcy Court.

Why do rating agencies enjoy this outsized importance in the markets, despite the fact that rating methodologies are often suspect at best, if not downright compromised?  

A simple example will illustrate the point. It is common knowledge now that commercial banks are required to maintain stipulated minimum levels of capital to support their assets, for example the loans they grant to companies. A bank’s capital adequacy ratio is not, however, based on a simple computation of available capital vis-a-vis the total loan book.

Every corporate borrower has its own risk weight which is directly linked to the credit rating awarded to it by a recognised rating company, such as CRISIL, ICRA or CARE or India Rating. Thus, a company with an ‘AAA’ or its equivalent rating – indicating the best possible rating grade – has a low risk weight of 20% while a ‘junk’ (or sub-investment grade) rating attracts a weight of 150%.

(The scale is notched at 20%, 30%, 50%, 100% and 150%.) What this, in turn, means is that if Bank X has two corporate borrowers, each with a loan line of Rs one billion  but one rated “AAA” while the other, say, ‘BB’, then Bank X will need to provide for capital as follows:

       For the ‘AAA’ rated borrower, on Rs 200 million (@20% of the exposure); and

       For the ‘BB’ rated borrower, on Rs 1.5 billion (@150% of the exposure).

What this means is the cost of the bank’s capital allocated for the lower-rated borrower is significantly higher than for the better-rated client. Clearly, the higher-rated client will expect to be quoted a far better price for its loans (plus other privileges) than the lower-rated one, quite apart from the fact that its high rating assures it of greater market acceptance and credibility. The RBI mandates these corporate ratings, along with – for now – insisting that banks will rely on these ‘external’ ratings (by the rating companies), and not on the banks’s own ‘internal’ risk ratings

A good rating from an established rating agency, therefore, attracts a premium, and will remain so as long as the ‘external’ ratings stay mandatory. So corporations are quite heavily invested in high credit ratings and the rating companies enjoy an assured, and friendly, market for their products. However, their risk measurement techniques are often seriously deficient, and they tend to rely inappropriately heavily on business projections and other disclosures made by their clients far too often. Cases like the IL&FS debacle are likely to recur as long as their inherently flawed business model (wherein they have a clear conflict of interest in being paid for their services by the very entities they are examining) stays put.

The IL&FS meltdown does, however, raise some other critical issues which we will try and look at a little more closely later.

Based out of Bangalore, Anjan Basu commentates on a range of issues. He can be reached at