 "RBI flags MFs' borrowing play; bank lines are in excess of Rs 1 trillion")
The central bank’s periodic Financial Stability Report has highlighted issues with the way mutual funds use banks as a liquidity stop-gap and suggested that the practice requires greater supervision.
Mutual fund regulations allow schemes to borrow money to meet temporary liquidity needs. The data suggest that this provision is perhaps being used as an indirect form of insurance, says the Reserve Bank of India’s (RBI’s) Financial Stability Report. Essentially, the provision allows mutual funds to load up on high-yield papers (which are often illiquid), and bet on banks bailing them out if liquidity issues emerge later, noted the report. It has warned of a “moral hazard” in letting this practice continue unchecked and recommended better supervision so that it does not worsen liquidity issues during stressed conditions. “…bank liquidity lines to MFs show a pro-cyclical approach, rising when the interest rate views are bearish and being flat otherwise. This implies a behaviour consistent with moral hazard, wherein liquidity insurance by financial intermediaries allow asset managers to load on yield-enhancing illiquid investments,” it said.
The liquidity on such instruments worsens during stressed conditions, such as the taper tantrum of 2013. This can have an adverse impact on banks too, noted the report. The amount of such borrowing is in excess of Rs 1 trillion, according to the recent RBI data based on bank lines to top 11 asset management companies (AMCs) representing 80 per cent of the aggregate assets. Private banks accounted for 40.9 per cent share in such borrowings, and are the largest players.
Increased oversight would be in line with the increased role that MFs play in the economy. “Over the years, mutual funds have been big players in debt market. They, now play a very large role in credit delivery mechanism. Availability of banking lines gives more flexibility to an asset manager in terms of liquidity of portfolios. As mutual funds become more systematically important, the RBI has rightly pointed out the need for greater monitoring of the overall debt exposures of mutual funds,” said Mahendra Kumar Jajoo, head (fixed income) at Mirae Asset Global Investments (India).
The MF regulations mention that schemes are currently allowed to borrow up to 20 per cent of their net assets to meet temporary liquidity needs.
While the Securities and Exchange Board of India’s (Sebi’s) re-categorisation has ensured that at least 80 per cent of a corporate bond fund is exposed to double A plus-rated instrument, there is no such definition that keeps a check on low-, short- or medium-duration funds. They can move to riskier, illiquid papers in search of returns said Vidya Bala, head (MF research), FundsIndia. “For now, AMCs do not go below A minus rated instruments. However, if MFs begin to stretch themselves thin on the risk and liquidity front, there will emerge a risk,” she said.
Industry participants have previously suggested to the Sebi that mutual funds should have a minimum liquidity requirement, which works similar to banks' statutory liquidity ratio. This could be in the form of some allocation to government securities or highly liquid corporate bonds.
Kaustubh Belapurkar, director (fund research), Morningstar Investment Adviser India said fund houses also use other avenues to manage liquidity. This includes the use of fairly punitive exit loads, reducing the concentration of investors to reduce redemption-risk, and staggering the maturity of their holdings for better cash management.
Another reason for taking on riskier paper in recent times is investors demand for higher yield. “A lot of funds flows have been coming into funds with higher credit risk. And investors have not been active in long-dated g-secs as yields have been volatile. It is natural that the mix of holdings would also move in favour of more risky paper as a result,” said Belapurkar.
Mutual fund regulations allow schemes to borrow money to meet temporary liquidity needs. The data suggest that this provision is perhaps being used as an indirect form of insurance, says the Reserve Bank of India’s (RBI’s) Financial Stability Report. Essentially, the provision allows mutual funds to load up on high-yield papers (which are often illiquid), and bet on banks bailing them out if liquidity issues emerge later, noted the report. It has warned of a “moral hazard” in letting this practice continue unchecked and recommended better supervision so that it does not worsen liquidity issues during stressed conditions. “…bank liquidity lines to MFs show a pro-cyclical approach, rising when the interest rate views are bearish and being flat otherwise. This implies a behaviour consistent with moral hazard, wherein liquidity insurance by financial intermediaries allow asset managers to load on yield-enhancing illiquid investments,” it said.
The liquidity on such instruments worsens during stressed conditions, such as the taper tantrum of 2013. This can have an adverse impact on banks too, noted the report. The amount of such borrowing is in excess of Rs 1 trillion, according to the recent RBI data based on bank lines to top 11 asset management companies (AMCs) representing 80 per cent of the aggregate assets. Private banks accounted for 40.9 per cent share in such borrowings, and are the largest players.
Increased oversight would be in line with the increased role that MFs play in the economy. “Over the years, mutual funds have been big players in debt market. They, now play a very large role in credit delivery mechanism. Availability of banking lines gives more flexibility to an asset manager in terms of liquidity of portfolios. As mutual funds become more systematically important, the RBI has rightly pointed out the need for greater monitoring of the overall debt exposures of mutual funds,” said Mahendra Kumar Jajoo, head (fixed income) at Mirae Asset Global Investments (India).
The MF regulations mention that schemes are currently allowed to borrow up to 20 per cent of their net assets to meet temporary liquidity needs.
While the Securities and Exchange Board of India’s (Sebi’s) re-categorisation has ensured that at least 80 per cent of a corporate bond fund is exposed to double A plus-rated instrument, there is no such definition that keeps a check on low-, short- or medium-duration funds. They can move to riskier, illiquid papers in search of returns said Vidya Bala, head (MF research), FundsIndia. “For now, AMCs do not go below A minus rated instruments. However, if MFs begin to stretch themselves thin on the risk and liquidity front, there will emerge a risk,” she said.
Industry participants have previously suggested to the Sebi that mutual funds should have a minimum liquidity requirement, which works similar to banks' statutory liquidity ratio. This could be in the form of some allocation to government securities or highly liquid corporate bonds.
Kaustubh Belapurkar, director (fund research), Morningstar Investment Adviser India said fund houses also use other avenues to manage liquidity. This includes the use of fairly punitive exit loads, reducing the concentration of investors to reduce redemption-risk, and staggering the maturity of their holdings for better cash management.
Another reason for taking on riskier paper in recent times is investors demand for higher yield. “A lot of funds flows have been coming into funds with higher credit risk. And investors have not been active in long-dated g-secs as yields have been volatile. It is natural that the mix of holdings would also move in favour of more risky paper as a result,” said Belapurkar.
The liquidity conundrum
- Mutual funds can borrow from banks to meet temporary liquidity issues
- Financial Stability Report notes that this allows them to load up on risky paper
- Banks acting as ‘liquidity insurance’ creates a ‘moral hazard’
- Liquidity issues can worsen during stressed conditions
- Report suggests more oversight to prevent such issues
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