GLOBAL FINANCIAL CRISIS, EVERGRANDE CRISIS & IL&FS CRISIS

GLOBAL FINANCIAL CRISIS, EVERGRANDE CRISIS & IL&FS CRISIS

20 Jan, 2023

GLOBAL FINANCIAL CRISIS, EVERGRANDE CRISIS & IL&FS CRISIS

Author – Taniya Suyash Shah, Student of O.P Jindal Global Law School

INTRODUCTION: GFC

“IF IT AIN’T BROKE, DON’T FIX IT”, by Thomas Lance clarifies that unless there is no significant evidence of a crash-down of markets, do not interfere with them.[1] Thus, the establishment of the Federal Reserve System in 1913 and finally the creation of the Federal Deposit Insurance Corporation by the Banking Act, 1933 in response to the Great Depression and the coexisting Glass–Steagall Act that separated commercial from investment banking to prevent bank failures.[2] Further under the Clinton governance, Gramm- Leach-Biley Act was passed allowing banks to engage in Underwriting, Regulating Credit Default Swaps, and Over-The-Counter derivative contracts. This roller coaster of deregulations subsequently came to rest only after the Sub-prime Mortgage Crisis in 2007-08. The following is the statement of the former Board of Governors from the 1980s when government interference in the banking sector was considered a problem.

The Global Financial Crisis in 2007-08, was daunting and collapsed the whole economy and in response, policymakers embarked upon the need to structurally regularise the financial system, calling it a “New Bretton woods moment”.[3]

Limitations of Universal Banking

  • UB creates an unhealthy monopoly of power in a way that the failure of one might have ramifications leading to a systematic financial crisis.
  • UB is extremely difficult to regulate as it is interconnected with business making it complex.
  • The bank officers go with the ideology that these banks are too big to fail and hence eventually take excessive risks.
  • The bank officials are very aware that the Government regulators would recognize the threat and would regulate the UB system tightly, the repercussions of which are to be forcefully borne by the taxpayers through a bailout.[1]
  • UB tends to connect and work with huge businesses, ignoring freshly started companies.
  • [1] George J. Benston Source, ‘Universal Banking’ (The Journal of Economic Perspectives, Summer, 1994, Vol. 8, No. 3, 1994), American Economic Association < https://www.jstor.org/stable/2138223> accessed on 6 October 2022

Measures to mitigate risks of Universal Banking

  • Firstly, as rightly mentioned in Basel III, the minimum capital requirements must be strengthened and the larger banks must be exposed to higher reserve requirements as they impose greater risk[1].
  • Investors don’t pay the Credit Rating Agencies, the companies do, who very well manipulate the CRAs in granting AAA ratings that eventually fool the investors. Strict penalties are to be implied to such CRAs in case they wash off their hands in case something goes wrong. For instance, in India, SEBI closed down the shutters for Brickwork Ratings on 6th October 2022 for the same reason[2].
  • As a measure to mitigate risk, the U.S Securities and Exchange Commission, adopted an identical Final Rule, section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act known as the Volcker Rule, that forbids any banking organization from engaging in proprietary trading, purchasing or holding an ownership interest in, sponsoring, or having certain connections to a hedge fund or private equity fund[3].
  • [1] CFI Team, ‘Basel Accords- A set of banking supervision regulations set by the Basel Committee on Banking Supervision (BCBS)’ (Corporate Finance Institute, updated 11 October 2022) <Basel Accords – Overview, Basel I, Basel II, Basel III (corporatefinanceinstitute.com)> accessed on 11 October 2022.
  • [2] Order in the Matter of Brickwork Ratings Private Limited, (Securities and Exchange Board of India, 06 October 2022) < SEBI | Order in the Matter of Brickwork Ratings Private Limited> accessed on 12 October 2022.
  • [3] Commissioner Luis A. Aguilar, Statement on the Volcker Rule: Reducing Systemic Risk By Banning Excessive Proprietary Trading with Depositors’ Money (U.S Securities and Exchange Commission, 10 December 2013)

Differences between Global Financial Crisis and Evergrande Crisis

  • “The biggest difference between the two is that Evergrande was a train wreck that everyone saw coming,” was the statement of Mr. Motwani, an analyst at Credit Suisse when Lehman collapsed[8], meaning that the Evergrande crisis was very well predicted by everyone, unlike the housing bubble that led to the 2008 GFC.
  • It was clear almost a year ago when the three red lines policy was introduced by China, that the Evergrande would eventually turn out to be its biggest offender[9]. In a way, it could be estimated that China was somehow ready to face this demon.
  • Another major difference in both crisis is that of Government Intervention. China’s government has control over the real estate industry in contrast to the limited government interference of the US over the investment banking sector.
  • Thus, after the meltdown of Lehman Brothers, the US had to come up with regulations such as the Dodd-Frank Act, consisting of Volcker’s Rule separating the roles of commercial banks and investment banks. On the other hand, China’s Government didn’t really have to come up with any regulations as there were existing regulations namely the “three red lines” which are a set of debt provisions that strictly restrict the capacity of specific Property Developers to borrow[10].
  • In Evergrande’s case, no bailout kind of situation arose wherein China’s Government bailed out the giant company, in fact, it is using more like a fragmentary tactic. “Beijing is like a surgeon operating on a tumour who is thinking ‘what do I need to save?’,” was stated by Alicia Garcia Herrero who is the chief economist of Natixis[11]. Whereas, in the GFC, huge investment banks like Bear Stearns, Goldman Sachs, and Merill Lynch, except for Lehman Brothers were either bailed out by the American government or acquired by another giant company.
  • Also, it is pertinent to note that, Evergrande holds assets in form of physical land in comparison to the financial assets held by the investment banks in the Global Financial Crisis.

Similarities between the Global Financial Crisis and the Evergrande Crisis

  • The basis of both crisis is the assumption that the housing sector/real estate sector shall never see a downfall.
  • Evergrande Company defaulted on its debt obligations and in GFC, the subprime borrowers defaulted on their payback of loans. Thus, in both cases, there has been default on the debt obligation.
  • There was a lack of transparency and accountability in the balance sheets of the investment banks in GFC and in the books of accounts of the Evergrande.
  • As the funds were available at low-interest rates, in both these cases, there was a high level of credit creation.
  • Also, we may conclude by stating that there were regulatory issues with both the countries, that is US and China which were not tightly imposed resulting in such a crisis.

China is as secretive as it has always been, and not disclosed the current situation of the Evergrande group. As per the reports, Evergrande group has recently failed to meet a self-imposed deadline for a restructuring proposal and two of its bosses have quit the group and the developers are inquiring to sell its Hong Kong headquarters. One thing we know for sure is that China’s Government would never let the Evergrande group go bankrupt due to major government intervention as the Communist Party of China is too big to fail in itself.

Infrastructure Leasing & Financial Services (IL&FS) and its subsidiary firms, formed India’s biggest infrastructure development and financial services firm, which defaulted to fulfill several debt obligations and began to default in the year 2018. The debt market in India experienced panic which had a domino effect on other financial services, specifically in the NBFC industry. The RBI, India’s financial watchdog, and the Indian Government promptly interceded to assist the business. They took prompt action, narrowly avoiding a complete financial catastrophe while rejecting a blanket bailout proposal and taking into account the company’s “too large to fail” size[12]. As a result, India was spared a “Lehman Brothers moment”[13].

INFRASTRUCTURE LEASING & FINANCIAL SERVICES (IL&FS) CRISIS

The causes that led to the IL&FS crisis in India can be explained as follows: –

  • In my estimation, the root cause of the IL&FS crisis is majorly the faulty structure of the NBFCs in which they borrow money on a short-term basis whereas they tend to invest in projects that are long-term creating a situation known as Asset Liability Mismatch[14].
  • In 2018, a subsidiary of IL&FS, IL&FS Transportation Networks Ltd, defaulted on loan repayment sending shockwaves through the Indian financial sector and resulting in banks being hesitant in granting loans to NBFCs.
  • The rating agencies continued to assign AAA ratings to the NCDs, and bonds, issued by the IL&FS up until July 2018 despite their knowledge that the group had been experiencing liquidity issues since 2015 thus questioning the authenticity of such agencies[15].

The Reserve Bank and the government responded with several measures to restore confidence and maintain stability.

  • Taking lessons from the Satyam scandal, the Government stepped into swift action and applied to the National Company Law Tribunal (NCLT) on Monday to remove the board of IL&FS[16].
  • Thus, a new team with experts such as Uday Kotak as its Chairman, Vineet Nayyar as its Vice Chairman, and Managing Director were appointed as new Directors.
  • The board then implemented cost-cutting measures and disinvestments through the sale of assets.
  • As on March 2022, IL&FS has been able to pay back debt amounting to Rs 55,000 crore which equals 90% of the overall estimated debt resolution value of Rs 61,000 crore[17].

CONCLUSION

Thus, due to too many subprime mortgages in the country, a financial bubble formed that burst, causing the GFC, which spread quickly to other areas of the American economy and the rest of the globe. The existence of a worldwide crisis was proved by economic statistics like the GDP or the volume of international commerce. The debt problem at Evergrande may have more effects than we can foresee. Talking about the Evergrande crisis, there will be effects on the Chinese economy whether or not the Chinese government intervenes, and whether it does so directly or indirectly. As a result, it’s critical to monitor any potential developments and their potential impact on the US stock market. In conclusion, the IL&FS crisis exposed several startling truths about how NBFCs operate and how they have grown to be an essential and substantial component of the economy. The regulators’ perspectives were altered due to the crisis, leading to several changes and reforms.

REFERENCES

1) John Armour and Others, ‘Principles of Financial Regulation’ (Oxford, 2016; Online Edn, Oxford Academic, 20 October 2016), <Https://Doi.Org/10.1093/Acprof:Oso/9780198786474.001.0001> accessed on 6 October 2022.

2) Eric Helleiner, ‘The Status Quo Crisis: Global Financial Governance After the 2008 Meltdown’ Oxford University Press.

3) George J. Benston Source, ‘Universal Banking’ (The Journal of Economic Perspectives, Summer, 1994, Vol. 8, No. 3, 1994), American Economic Association < https://www.jstor.org/stable/2138223> accessed on 6 October 2022.

4) CFI Team, ‘Basel Accords- A set of banking supervision regulations set by the Basel Committee on Banking Supervision (BCBS)’ (Corporate Finance Institute, updated 11 October 2022) <Basel Accords – Overview, Basel I, Basel II, Basel III (corporatefinanceinstitute.com)> accessed on 11 October 2022.

5) Order in the Matter of Brickwork Ratings Private Limited, (Securities and Exchange Board of India, 06 October 2022) < SEBI | Order in the Matter of Brickwork Ratings Private Limited> accessed on 12 October 2022.

6)Commissioner Luis A. Aguilar, Statement on the Volcker Rule: Reducing Systemic Risk By Banning Excessive Proprietary Trading with Depositors’ Money (U.S Securities and Exchange Commission, 10 December 2013)

7) Mariko Oi, ‘Evergrande: China’s efforts to contain its Lehman moment’ BBC News (20 December 2021)

8) Vijaya Mandal and S.S. Prasada Rao, ‘Lessons from the IL&FS Financial Crisis’, (2019) The Proceedings of the 2nd International Conference on Business and Management ICBM  638

9) Malankar, Mrudula, and Smita Jape. ‘The study of pre and post-effect of Non-Banking Financial Company’s crisis in India.’ Publication Ethics Policy 42.

 10) Dr. Arab Mohammed Shamiulla and Ors., ‘Sebi Disclosure Norms – Professional Compromise by Credit Rating Agencies – A Case For Legal Study’ (2020) Volume 7 (11) Gis Science Journal 1588.

11) Abhirup Roy and ors., ‘Government takes control of infrastructure group IL&FS to stem contagion’ (Reuters, 2 October 2018) < https://www.reuters.com/article/india-il-fs-copy-idINKCN1MC072> accessed on 9 October 2022.

12) Piyush Shukla, ‘IL&FS Board resolves Rs 55,000 crore debt so far: 5 key questions answered’ (Money Control, 30 March 2022) < https://www.moneycontrol.com/news/business/ilfs-board-resolves-rs-55000-crore-debt-so-far-5-key-questions-answered-8295671.html> accessed on 9 October 2022.

[1] John Armour and Others, ‘Principles of Financial Regulation’ (Oxford, 2016; Online Edn, Oxford Academic, 20 October 2016), <Https://Doi.Org/10.1093/Acprof:Oso/9780198786474.001.0001> accessed on 6 October 2022

[2]  ibid

[3] Eric Helleiner, ‘The Status Quo Crisis: Global Financial Governance After the 2008 Meltdown’ Oxford University Press

[4] George J. Benston Source, ‘Universal Banking’ (The Journal of Economic Perspectives, Summer, 1994, Vol. 8, No. 3, 1994), American Economic Association < https://www.jstor.org/stable/2138223> accessed on 6 October 2022

[5] CFI Team, ‘Basel Accords- A set of banking supervision regulations set by the Basel Committee on Banking Supervision (BCBS)’ (Corporate Finance Institute, updated 11 October 2022) <Basel Accords – Overview, Basel I, Basel II, Basel III (corporatefinanceinstitute.com)> accessed on 11 October 2022.

[6] Order in the Matter of Brickwork Ratings Private Limited, (Securities and Exchange Board of India, 06 October 2022) < SEBI | Order in the Matter of Brickwork Ratings Private Limited> accessed on 12 October 2022.

[7] Commissioner Luis A. Aguilar, Statement on the Volcker Rule: Reducing Systemic Risk By Banning Excessive Proprietary Trading with Depositors’ Money (U.S Securities and Exchange Commission, 10 December 2013)

[8] Mariko Oi, ‘Evergrande: China’s efforts to contain its Lehman moment’ BBC News (20 December 2021)

[9] ibid

[10] ibid

[11] ibid

[12] Vijaya Mandal and S.S. Prasada Rao, ‘Lessons from the IL&FS Financial Crisis’, (2019) The Proceedings of the 2nd International Conference on Business and Management ICBM  638

[13] Ibid

[14] Malankar, Mrudula, and Smita Jape. ‘The study of pre and post-effect of Non-Banking Financial Company’s crisis in India.’ Publication Ethics Policy 42.

[15] Dr. Arab Mohammed Shamiulla and Ors., ‘Sebi Disclosure Norms – Professional Compromise by Credit Rating Agencies – A Case For Legal Study’ (2020) Volume 7 (11) Gis Science Journal 1588.

[16] Abhirup Roy and ors., ‘Government takes control of infrastructure group IL&FS to stem contagion’ (Reuters, 2 October 2018) < https://www.reuters.com/article/india-il-fs-copy-idINKCN1MC072> accessed on 9 October 2022.

[17] Piyush Shukla, ‘IL&FS Board resolves Rs 55,000 crore debt so far: 5 key questions answered’ (Money Control, 30 March 2022) < https://www.moneycontrol.com/news/business/ilfs-board-resolves-rs-55000-crore-debt-so-far-5-key-questions-answered-8295671.html> accessed on 9 October 2022.

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