Money & Banking

Open-ended debt funds particularly susceptible to a ‘run risk’, says RBI study

Our Bureau Mumbai | Updated on June 11, 2020 Published on June 11, 2020

To address the risks and spillovers faced by mutual funds, the markets regulator should consider bringing in a stipulation whereby the ratio of government securities in incremental holding goes up as the size of the debt scheme increases, a Reserve Bank of India (RBI) study has recommended.

The suggestion comes in the backdrop of the recent episode of a debt portfolio manager halting withdrawals. This has brought the spotlight to bear on the functioning of open-ended mutual funds in times of crisis.

“Given the issues of incentive compatibility through bail-out mechanisms and attendant moral hazard issues brought in by size, there is clearly a need to balance the growth in AUM (assets under management) with additional liquidity buffers to moderate risk and spillovers.

“One particular way to address the same may be through stipulating that the ratio of government securities in incremental holding should increase as the size of a debt scheme increases,” the study’s authors, Yaswant Bitra, Manish Meena and Anubhav Agarwal of the RBI’s Financial Stability Unit, wrote.

Dramatic growth

In recent times, the dramatic growth in resources flowing to mutual funds suggests a discernible shift in the pattern of deployment of financial savings in India. Net AUM of debt/income oriented mutual fund schemes have grown from ₹6.94 lakh crore as at end-March, 2015 to ₹11.97 lakh crore as at end-March, 2020, an increase by about 70 per cent in a span of 5 years.

The authors underscored that offering Mutual Fund units repayable on demand where the net asset value (NAV) impact is passed through to the investor is akin to offering deposits repayable on demand as in banks but without the cushion of high quality liquid assets (HQLAs)/reserve requirements/lender of last resort. Hence, it said, this amounts to significant regulatory advantage.

The issue is particularly relevant for jurisdictions where the investor base is narrow/concentrated and secondary debt markets are illiquid, they added.

‘Run Risk’

“In India, SEBI introduced a risk management framework for liquid and overnight funds which posits that liquid funds will hold at least 20 per cent of their net assets in liquid assets. Nonetheless, there are specific features of Indian markets, which make open-ended debt funds particularly susceptible to a ‘run risk’,” the authors said.

Corporates and high net-worth individuals (HNIs) comprise more than 90 per cent of the aggregate assets under management (AUM) of debt funds; in sharp contrast, their share in equity funds is 48 per cent.

Vulnerabilities

According to the Study, vulnerabilities of the open-ended debt mutual fund model in India get accentuated by the shallow secondary corporate debt markets.

The authors said two design features of the MF industry micro-structure stand out. First, debt MFs’ investor profile makes them particularly more susceptible to a run.

Second, in the case of large correlated withdrawals, specifically during stressed times, when credible counterparties are absent to provide liquidity, markets witness large swings in prices, accentuating risk aversion.

“Sound policy frameworks should be supported by credible and effective financial safety nets, reinforced by short-term liquidity support from central banks. However, any amount of liquidity support cannot address solvency issues, weaknesses in investment design and incentives thereof for fund managers, and a widespread risk aversion,” the RBI officials opined.

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Published on June 11, 2020
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