IL&FS crisis shows why babus shouldn’t run businesses

Bureaucracy is at the heart of the mess at IL&FS. Officials have no incentive in making profits. They pay no price even if the company run by them fails.

Enough is written and commented on the brewing crisis in the Infrastructure Leasing & Financial Service (IL&FS). However, most pundits have ignored one of the crucial reasons for the origin of the crisis in the first place – BUREAUCRATIC INCENTIVES.

Let’s first understand the situation completely in a few points:

  • IL&FS is a non-banking financial company which funds large infrastructure projects. These projects include national highways, metro construction, power-plants, etc. IL&FS has more than 250 subsidiaries, associates, and joint-venture companies under its management.
  • Government-owned Life Insurance Corporation of India is the largest investor in the company with over 25 percent ownership. Other public sector undertakings own at least 13 percent of the company and some investment in the firm also comes from foreign governments and firms.
  • In August 2018, IL&FS defaulted on some of its debt to the Small Industries Development Bank of India. The company has over ₹90,000 crore of consolidated debt with dues equating to about ₹3,700 crore in the second-half of 2018. However, it has only about ₹200 crore to meet these obligations.
  • The panic emanating from IL&FS defaults, and other factors such as falling rupee, high oil prices, etc. have already caused the BSE Sensex to lose over 2000 points in the last few days and has eroded 12.5 percent of mutual funds’ assets.

A default from IL&FS will further cause distress in the Indian banking industry which is already under enormous pressure from increasing non-performing assets.

The main reason for the crisis at IL&FS is the management of the firm by bureaucrats. Let me first clarify, bureaucrats are not bad people, they are rational human beings just like the rest of us. They do what is in their best interest, and that is the problem. What is in the best interest of a bureaucrat may not be in the best interest for a firm or the economy.

Incentives matter

When the government is involved in running businesses, it usually results in losses. This doesn’t happen because the bureaucrats are incompetent, it is the general consequence of having misaligned incentives. A private company is driven by profit. It knows that if it fails to do that, it will go bankrupt. A management headed by bureaucrats doesn’t have this problem, they face no consequence for being wrong. Their salaries and benefits continue as if nothing happened.

In July 2018, sensing the trouble ahead, the largest shareholder of IL&FS, the LIC appointed Hemant Bhargava as the chairman of the company. Mr. Bhargava is a career bureaucrat and has served as the Managing Director of LIC in the past. Bureaucracy and business are a dangerous mix, and it was proved as the trouble started for IL&FS in August. Under new chairmanship, the firms’ position further deteriorated so much so that Mr. Bhargava had to step down as the chairman in mid-September.

Repeating history, the new management appointed by the government is again made-up mostly of former bureaucrats. We will just have to wait and watch how long the company will sustain under this management. As much as the government wishes that bureaucrats will have a public conscience and act in public interest, as self-interested human beings, bureaucrats are quite incapable of it.

Further, companies run by government lack accountability. Instead of being accountable to shareholders and taking only manageable risks like any other private enterprise would do, they take higher risks as the management pays no cost for being wrong. Officials running government-controlled companies always know that the government will support them with taxpayers’ money when they make losses. The worst that can happen to a bureaucrat is reassignment to some other company or department. We have witnessed hundreds of such incidents, this won’t be the last.

The only way to stop one bureaucrat-led crisis after another, we must stop the government from doing business.  

Read more from our daily section.