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India’s financial markets have been a flutter recently after Franklin Templeton’s (FT) decision to close six of its debt funds under redemption pressures. These six funds had large exposures to high-yield, lower-rated AA and A bonds. Many of these investments reportedly seem to violate normal prudent investment principles
like sector concentration and singleborrower limits.
FT’s decision led to a mild panic as mutual funds (MFs) across India rushed to reassure investors as redemption pressures grow. In reaction, the Reserve Bank of India announced on April 27 a liquidity facility for banks to prop up MFs, an action that could easily have been taken much earlier.
Naturally, market participants, individual investors and corporations seeking a modicum of stability in corporate debt markets have all lookedto the Securities and Exchange Board of India (Sebi) for leadership on this matter. While Sebi’s role of coordinating with RBI and the finance ministry to renew confidence in these markets is crucial, one should look at the first line of defence that failed: the fund’s trustees.
Sebi’s role has been primarily in the form of disclosure-based regulation, which requires listed securities to reveal all associated risks. But these disclosures are often dense, full of jargon and voluminous, which means understanding these documents in their totality is beyond the scope of the average investor.
It is neither realistic nor desirable for Sebi to micro-monitor transactions. It would be better that these disclosures explicitly state the risks taken on by investors. Entities like MFs undertake the specialised task of understanding securities and their associated risks, and assembling a portfolio to match the risk appetite of unit-holders.
The first line of investor protection in MFs is supposedly the trustees, whose responsibility is explicitly to protect the interests of unit-holders.
Their appointment requires Sebi approval. Ideally, trustees should be fully involved in all investor protection-related activities — a say in the selection of fund leadership; in establishing internal control mechanisms; in maintaining compliance through quarterly reviews of transactions; reviewing all reports submitted to Sebi; etc. If unit-holders of an MF are forcing redemption, then it is not only the asset managers who are at fault but, by implication, so are the trustees.
Beast of Burden
The unfortunate reality of the MF market in India is that it is not just a vehicle for households to gain access to securities markets. It has also become a vehicle for inter-corporate deposits. Large corporations swimming in liquidity often prefer to park their cash in shorter-duration MFs, which provide better short-term returns than less risky options like government securities or AAA corporate bonds.
As a result, there is a deep interdependency between large Indian corporations today, as they constantly lend each other money through MFs.
At some point after the 2007-08 financial crisis, more adventurous asset managers started buying debt from smaller companies, who were (and remain) completely starved for capital in India, and are often willing to promise much higher return on short-term debt. This is what most of the FT MFs portfolio consisted of — AA- and A-rated debt of smaller, riskier companies.
It is in these situations that one yearns for a deep, liquid corporate bond market, which would offer flexible borrowing options to corporations for short-, medium- and long-term liquidity. Short-run MFs provide a poor substitute for such a market, whose near complete absence of this market has repeatedly hurt India.
Despite considerable efforts of Sebi, this market has been a non-starter in India primarily on account of perceived and real turf battles.
Multiple layers of regulation need to be built in or strengthened to minimise such incidents from recurring. In addition, these recent crises need to be used as a trigger for basic regulatory and banking reforms.
These long-pending reforms have been fully articulated in the reports of various committees of the finance ministry, RBI and Sebi.
More Windows
The non-performing asset (NPA) problem, for instance, has taught us that over-reliance on bank-financing to run large parts of the economy is problematic, especially if banks collectively make bad credit decisions.
Having multiple channels of credit open to firms, including a corporate bond market, would help firms diversify their credit risks.
The current legislative and policy frameworks, and regulatory practices in India are leading to all kinds of circuitous forms of lending through inter-corporate debt, MFs and multiple layers of intermediation. This is a good time to revisit these legislative and institutional frameworks, and reform them.
Krishnan is former secretary, GoI, and Chandra is fellow, Centre for Policy Research, New Delhi
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