Even as the micro facets of the Franklin Templeton (FT) incident unravel, we must also look at what this means for systemic risk because mutual funds (MFs) are now increasingly resembling banks on both sides of their business. Debt schemes form more than 53 per cent of their AUM (assets under management) of ₹22 trillion; over 50 per cent of liability is debt, and over 50 per cent of the debt is to corporates and public sector units, both short and long term.

Though the financial stability reports of the RBI discuss systemic risks, they are largely bank-centric. But redemption pressures in MFs are the equivalent of a bank deposit run-off which is why the RBI had to act quickly by opening up a credit line to banks to bail out MFs. Credit risk of MFs has been a long-time concern but SEBI’s approach in this regard seems to have been incremental. The logic behind the new debt fund categorizations, for instance, seems fuzzy in hindsight.

Not mutually exclusive

For one, the 16 new categories are not mutually exclusive — 10 are by duration, two by liquidity, two by sector and two by strategy; the overt focus on duration-related risks (price and interest risk) seemed to suggest that credit risk was less of an issue. The absence of exposure or credit quality norms for duration funds left a door open for MFs to try and generate higher returns in low-duration schemes, perhaps assuming credit risk would be low in short-term funds.

Five of the six schemes that FT shut down were duration funds where over 40 per cent of paper were ‘A’ or below (as much as 62 per cent in one fund). The real problem with low-rated paper, as FT discovered, was that it could be highly illiquid in the best of times. Searching aggressively for higher yields, it seems to have packed its two short tenor schemes with corporate debt and bonds with low liquidity.

Apart from credit quality, the exposure to core sectors such as power, infrastructure and real estate also meant that short-term debt had perhaps been utilised for financing long-term projects. Banks have much higher levels of bad debt but they could weather liquidity risks because of superior core liquid asset buffers (SLR, CRR), more stable CASA deposits that flowed from the payments rather than lending business and, most importantly, their lower risk appetites. Not so MFs, where liquidity risks are elevated by two factors — investors in the non-liquid debt schemes are predominantly (over 50 per cent) institutional which means flight risk is a constant threat and, two, the compulsions of a return maximising model which require liquid assets to be kept to the minimum.

Thus, while short-term liabilities of MFs (53 per cent of debt schemes are one year or less) are technically backed by liquid assets, these include a large portion (37 per cent) of CPs of corporates and NBFCs. As the IL&FS and DHFL incidents showed, CPs can be risky too. Though MFs have about 45 per cent invested in corporate debt and bonds, most of this is parked under longer debt schemes where redemption pressures have not been intense yet.

But if other MFs have also been financing long-term projects in core or infrastructure sectors, credit risk could be lurking in other debt schemes too. In fact, redemption data show that credit risk and medium duration schemes have been witnessing negative outflows continuously for over a year now, suggesting maybe that savvier investors have already smelt trouble in these bonds.

Room for concern

There is, therefore, enough reason for the RBI to be concerned from a system perspective. In the past, the RBI had viewed the flows into MFs as a stabilising factor to counter the volatility of FII investments. But now it is their lending that is causing concern. Undoubtedly asset markets and players are different — institutional (68 per cent) and HNI (29 per cent) investors dominate MF debt investments — which suggests MFs are being viewed as a giant treasury management machine.

Therefore, differential standards exist with banking regulations driven by systemic concerns and MF regulations investor oriented. But when roles get blurred, there needs to be greater commonality while, at the same time, recognising interconnectedness risks because MFs are also one of the largest suppliers of liquidity (28 per cent) in the system. Therefore any changes impacting their liquidity could quickly spill over to other segments.

The writer is an independent financial consultant

comment COMMENT NOW