Empower Debt Market Investors With More Information, Protection Will Follow
The Securities and Exchange Board of India, the ever-vigilant market watchdog, has had its hands full, of late. Some time back it was disciplining credit rating agencies. Currently, SEBI is focused on mutual funds.
The latest SEBI regulations on mutual funds are a continuation of the effort to protect retail investors. However, the jury is still out on whether the predominantly rule-based regulatory actions will treat the symptom or the disease. Rule-based regulatory setups, globally, tend to dispense narrowly-defined rules. At times, such rules lead to unintended consequences including, but not limited to, distorting markets and stifling financial innovation. To treat the Indian debt markets, it may be argued that SEBI need to try more and diverse regulatory approaches.
Same Disease, Different Symptoms
On the face of it, JP Morgan Mutual Fund’s hiccups with Amtek Auto’s non-convertible debenture, the IL&FS debacle and the more recent Franklin Templeton fiasco may appear to be dis-jointed events. The actors and props are of course the same - corporate debt, credit rating agencies and mutual funds but the script different each time.
The events point to a systemic inadequacy in credit risk management, despite pockets of excellence. The risk built up was aggravated further by weak disclosure levels and chronic information asymmetry. A few market participants, with compromised corporate governance, tried to take advantage of that shortcoming, till market liquidity exposed them. To the extent, comprehensive risk management is an important attribute of corporate governance, SEBI, the regulator for such entities, should be concerned.
Reactive, Tactical And Narrow
While some regulatory attention has been given to specific aspects of mutual fund investments (more on that later) – the focus on governance around investment decision making at mutual funds has been limited. The retail investor could have done with higher level of disclosure about mutual fund investment operations.
Also, while the regulator has attempted to remedy the funds’ missteps it has remained silent on the role credit rating agencies played in these fiascos. That the debt schemes were rated based on, largely, the credit rating of the papers shows a certain lack of competence. Debt funds are as likely to lose money due to credit loses as due to (il)liquidity of bonds. That the scheme’s rating did not lay enough emphasis on liquidity risk is a disservice to investors. To the extent such gaps are not addressed by the regulator, they may breed more fiascos in future.
‘Skin In The Game’ – No Panacea By Itself
Recently, SEBI released rules on compensation for key personnel at mutual funds with the commendable objective of aligning the interest of these employees with investors of the fund’s schemes.
The solution was directed at forcing ‘skin-in-the-game’.
Now take a moment to recall that the famous rogue trader Nick Leeson who brought down Barings, the oldest merchant bank in the United Kingdom, had skin in the game. Executives of Enron also had skin in the game. But what they did was to hide losses, cooked books, and get rewarded for the perceived ‚good‘ performance. Point being, without improving disclosure levels and governance, just pushing for perceived accountability with skin-in-the-game has limited benefits.
Even if outright fraud were to be ruled out, it may be argued that tying a fund manager’s compensation with the returns of a scheme she manages does not always serve investor interest.
Take the hypothetical case of a fund manager of a credit-opportunity fund, known for her aggressive investment style. Investors may have invested in the scheme for those aggressive returns. But to protect her compensation the fund manager may play conservatively and miss out on returns, thus doing a disservice to the investor. The rule may potentially alter the behaviour of a fund manager to the detriment of the investor.
Focus On Investors’ Decision Making Process, Not Outcome
SEBI’s other recent rule has mandated valuation methods for corporate debt paper with embedded put option. Arguably, the trigger for this rule is a recent mutual fund episode, where allegedly the fund manager did not exercise the put option to redeem the bonds when the bond’s credit quality was deteriorating. The put option allows fund manager to ask for the bond to be paid back well before its maturity. This option is useful if the manager feels that the bond’s default risk in rising. The SEBI rule now requires the fund manager to disclose reasons for not exercising the put-option. For all one knows, the fund was possibly waiting for an even more opportune moment to exercise the put-option.
Further, if the option is not exercised, SEBI has mandated that valuation agencies will not consider the put-option when valuing the bond. Given that the option remains embedded and can be exercised, the economic value of such a bond will be higher than the regulatorily mandated value. Since, the mandate may cause the bond to be officially undervalued, it creates an opportunity for other institutional investors to make an arbitrage profit to the detriment of mutual fund investors.
Proactive Regulation For Structural Improvement
Bonds with embedded put options can offer undue flexibility to corporate borrowers to roll-over the payment of their debt. This is often observed in markets where corporate default information is not easily accessible.
As such, the debt mutual fund investor is the worst victim of such information asymmetry in the debt market. Banks would be the first to become aware of a potential default situation arising thanks to their access to Reserve Bank of India’s Central Repository of Information for Large Corporates and the Commercial Credit Bureau. Mutual funds do not have access to these data sources. As such, due to cross default clauses, one default paints all the borrower’s debts in red. Yet the fund, valuation agencies and investors are in the dark. Such information asymmetry is a breeding ground for trouble. It potentially gives fund managers an opportunity to enter cozy deals in situations where the bond has unexercised put-options.
Here, at times, the put option may end up being exercised not because of the fund manager’s credit view on the corporate, or the market view, but because it may be convenient from a regulatory compliance perspective. A reduction in the information asymmetry and increasing transparency of decision-making in mutual funds may be more impactful options for SEBI.
Empowering Retail Investors Is A Better Way Of Protection
Investors are asynchronously talented individuals. The regulator expects them to be innocent enough to require a mutual fund’s help to invest, while simultaneously understand an advanced concept like ‘market risk’ and “consider” that before investing in mutual funds. While protecting investors is good, the regulator could consider mandating funds to share more information with them.
The following information can be furnished, on the investment-related operations of the mutual fund:
The quantum of assets transferred between institutional schemes and retail schemes and at what prices.
Investor concentration of each scheme.
Peak redemption the scheme has seen in the past and how it compares to the cash position of the fund.
Access to liquidity facilities the fund may have.
Share retrospectively, say with a lag of 12 months, the detailed minutes of investment committee minutes.
Deep Narayan Mukherjee is a financial services professional and a visiting faculty on risk management at Indian Institute of Management, Calcutta.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.