RBI Paper Suggests Higher Government Bond Holdings For Large Debt Funds

A paper authored by Reserve Bank of India staffers suggested that larger debt mutual funds should be asked to invest a prescribed amount in government bonds to help counter a sudden liquidity squeeze brought on by bunched up redemptions.

The paper was published in the RBI’s June bulletin. It comes soon after the central bank opened a special liquidity facility for mutual funds facing redemption pressures. In April, the RBI announced a Rs 50,000-crore special liquidity facility for mutual funds, of which only Rs 2,430 crore has been utilised. The central bank has had to do this during past crisis as well.

“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 assets under management with additional liquidity buffers to moderate risk and spillovers,” said the RBI paper. “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,” it suggested.

Mutual Funds Vs Banks

The paper draws a comparison between banks and mutual funds.

While banks, which hold deposits repayable on demand, are asked to set aside a specified amount of funds with the RBI and in highly liquid assets, mutual funds are not required to do so.

“Offering mutual fund units repayable on demand where the net asset value 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/ reserve requirements / lender of last resort and hence amounts to significant regulatory advantage,” the authors wrote. “The issue is particularly relevant for jurisdictions where the investor base is narrow/concentrated and secondary debt markets are illiquid.”

Investor Profile Of Debt Mutual Funds

According to the paper, corporates and high net worth individuals comprise more than 90% of the aggregate assets under management of debt funds. Their share in equity funds is at 48%.

In fact, HNIs and corporates comprise the majority of investors in debt funds, whereas for equity funds retail investors and HNIs comprise close to 90 percent of the investors in terms of AUM.

While current regulations try to prevent concentration risk by limiting the contribution of a single investor, this may not be enough. If corporate investors choose to distribute their surplus over a few fund houses, a quick exit during stressed times may still lead to concentrated exit and a systemic risk.

Meanwhile, debt fund portfolios tend to be illiquid. Debt fund tend to show significant pro-cyclical behaviour by loading of “spread risk” when interest rate views are not benign and the resultant illiquidity of the portfolios is sought to be partially resolved through bank credit lines. “Such arrangements have inbuilt spillover of liquidity risk from the corporate bond market to inter-bank funding market.”

Concentration Risks

During turbulent times banks and other institutional investors shut themselves out of market activities due to risk-aversion, significant loan exposures to particular borrowers or because of regulations surrounding their risk and exposure limits.

This could lead to a reliance by private NBFCs on mutual funds for funding. This is “a possible spillover route through which stress in this particular segment of the financial sector may affect funding to the real sector,” the paper said.

Most debt funds invest in debt securities of banks, term-lending institutions, financial services and housing finance companies. The financial services sector accounts for 69.3% of total corporate bond holdings, with most funds emphasizing securities of private entities, the paper found.

Since debt funds provide an important source of funding to private NBFCs, there is a “significant bunching of maturity” particularly for commercial papers maturing upto 90 days, the paper said. Whereas for mortgage lenders, the investment is spread out towards longer dated CPs, it added.