The Franklin Templeton Debt Fund Saga: Time to Reform the Shadow Banking System?
The announcement by Franklin Templeton Mutual Fund [FT] regarding suspension of 6 of its debt mutual fund schemes has been met by investors with a variety of emotions – ranging from disbelief to anger. Understandably so! For long, many of these schemes were sold for their superior returns despite having same promised liquidity and ‘similar’ credit risk profile to the competing schemes of other AMCs. There have already been several analyses about the credit quality of the FT debt fund portfolios and possible effects of this move on other debt mutual funds. Instead, this article focuses on the underlying causes that contributed to this turn of events and the possible regulatory changes to make this ecosystem robust enough to avoid the recurrence of such situation.
The liquidity illusion
In FT’s defence, the announcement is not about default by the companies that make up the portfolios of these schemes (though that may yet happen on account of the economic slowdown in the wake of Covid-19). The reason for FT’s drastic move was lack of liquidity. Despite having a large proportion of illiquid assets, these schemes themselves were open-ended. This was always going to be a precarious situation. While the going was good, FT’s schemes had net inflows of AUM month after month. Hence liquidity promise of the open-ended schemes was never put to test. Some newspaper likened this evolution to the proverbial ‘riding of the tiger’ story where a girl rides a tiger not knowing how to get off it without being eaten. There is no choice but to keep riding!
The promise of liquidity of FT’s schemes (and of many other debt mutual fund schemes in general) is, in reality, an illusion. These schemes are trying to behave like banks without the regulatory backstops and institutional arrangement that allow banks to be banks! Let us see how.
A bank takes deposits – savings, current and fixed – with a promise to repay on demand. However, on the asset side, banks lend to companies and individuals without a similar arrangement i.e. the borrowers have fixed tenors and banks do not have the right to recall a loan ahead of schedule. How, then, do banks manage to match these fixed-term assets against always-available liabilities? The answer lies in three important characteristics of banking system.
· First reason is institutional. Banks are the providers of payment systems. As a result, most people keep their money in banks as a default choice – creating a ‘baseload’ of deposits that never leave the overall banking system.
· Second reason is deposit insurance. For retail depositors, deposits are covered against default by bank up to Rs. 5 lakh.
· Third reason is central bank backstop. To the extent that a bank is creditworthy in the eyes of the central bank, it can get a fairly large amount of liquidity from the central bank (against collateral). That alone assures depositors that they do not need to worry about their bank going through a spiral of lack of liquidity leading to lack of solvency.
Several open-ended mutual funds have an asset-liability mismatch not quite different from that of banks. However, they have neither of the above three underlying hedges for such an unbalanced position. Their liquidity, hence, is a fair-weather friend. It is around only as long as everything is normal. That is different from a bank’s liquidity. Unless the credit quality of the assets of the bank is in question, a bank enjoys all-weather liquidity. Seen in this light, what prompted the FT announcement is effectively a “run on the mutual fund” similar to a “run on the bank”. The FT management saw the writing on the wall – there was just no way to sell the assets at the rate at which the investors were asking for their money back. Since mutual fund regulations allow such a move, they chose it.
The shadow banking system of India
A major factor contributing to this outcome – other than the trigger of Covid-19 crisis – is the evolution of a shadow banking system in Indian debt markets through the last decade. To be clear, I do not mean this is a ‘shadowy’ or illicit system in some way. I only mean that it is a system that walks somewhat like a banking system, talks somewhat like a banking system and quacks somewhat like a banking system but isn’t quite a banking system (to borrow the famous ‘duck’ aphorism!).
The first link in the chain is retail and institutional investors looking for above-FD returns. Most FDs with short-term maturity offer returns significantly below the short-term government securities. Given this, the most obvious product for a mutual fund to offer is a collection of government securities that are highly liquid and have a short tenor – the good-old Money Market Mutual Fund (MMMF). Since investors in such funds collectively need only so much of liquidity on a daily basis, statistically such a fund can always meet redemption obligations even while keeping bulk of its holdings in short-term G-secs. If there is a sudden surge in redemption demand, the fund can always sell its G-sec holdings in the open market. This market for government securities has many other participants including banks and even the central bank (through its open market operations). Hence it is rather unlikely that liquidity in this market would ever evaporate. To use our earlier terms, the liquidity here is all-weather!
An MMMF of this sort has its situation similar to that of banking system because there can hardly be a run on an MMMF scheme made entirely of G-secs. At worst, it can fully liquidate and hand over the money to its investors. Such a set-up is NOT shadow-banking system that I am referring to.
What made the system move into shadow-banking and thus become extremely fragile is the competition amongst funds to offer better yields on ‘liquid’ funds. This led to emergence of so-called ‘ultra-short term’ funds and ‘liquid-plus’ funds. The supply side to sustain this competition came from NBFCs. As the mutual funds started to manage larger and larger AUMs in their debt schemes, they started to look beyond government debt in search of yields. NBFCs on the other hand were looking for source of funding besides banks. One specific area of convergence was the market for commercial paper (CPs). Since CPs have short tenor, NBFCs could get away with lower cost of borrowing. On the other hand, since the tenors were short, mutual funds could live in the (illusive) comfort that the credit risk of these papers was quite low.
Individually, the credit risk of a short-term paper is indeed lower than that of the longer-term paper of the same issuer. However, this assumes that it is not a systemic occurrence. This assumption was (and continued to be) violated as majority of NBFCs started to fund larger and larger proportion of their balance sheet with short term liabilities. The roll-over was always on since mutual funds were fine to lend again after the maturity of previous issue.
The other side of NBFCs’ balance sheet was not as liquid. Their assets ranged between 3 years’ maturity (SME lenders) to 10 years’ maturity (housing finance). As one can guess, this link in the chain is also a fragile system. One instance of reduced roll-over can send the NBFCs scurrying for liquidity since their underlying assets do not have the maturity profile that allows survival without refinance. This chain i.e. yield-hungry investors to short term debt funds to NBFCs to (mostly) retail borrowers is one part of the shadow banking system. One can see that collectively this chain rivals the depositor-bank-retail borrower chain.
A parallel component of the shadow banking system on the corporate side was the so-called credit risk funds. These funds invested in the long-term debt instruments issued by companies. The companies saw it as an alternate source of funding. The mutual funds saw it as a way to get higher yield by taking calculated credit risk. The theory is sound. If one spreads credit risk across more than 20 issuers across different sectors, the only major risk one runs is that of macro shocks like Covid-19. Other than that, the increased yield on the diversified credit portfolio seems like a credit arbitrage in a country like India that has limited options beyond banks for corporate borrowers. Also, in the recent years, the major lenders to companies viz the PSU banks were anyway battling their own demons of past excesses on mega-loans gone bad and had reduced lending. It made sense for this chain of investors to credit funds to companies to compete with the chain of depositors to banks to corporate borrowers.
The cracks in the shadow banking system
It has become painfully clear over the last one year (since the IL&FS crisis) that the shadow banking system is extremely fragile. The IL&FS crisis brought home this point in the context of the retail loans component of the system i.e. investors to short term debt funds to NBFCs to retail borrowers. Back in second half of 2019 (seems so far now!) we had the troubles of housing finance companies percolate into those of debt mutual funds. Most of them survived (at least so far!) only because the housing finance troubles did not spread beyond default by one NBFC.
The FT announcement has made clear the fragility of the corporate leg of the shadow banking system. As noted earlier this was because the inherent mismatch of the tenor and liquidity of assets of the debt funds and their liabilities on account of being open-ended. What makes matters worse for such a system is a self-fulfilling feedback loop between reduced liquidity and increased demand for it by investors. When there is a fear of liquidity in the underlying assets drying up, investors rightly choose to head for the exit. This brings about the very scenario that the system is not prepared for. The penny drops!
The sources of fragility of this system are summarizes below.
a. Being open-ended in liabilities but longer-tenor in assets
b. Having only a fair-weather liquidity in considerable portion of the portfolio
c. Having no backstops in the event of a “run”
Regulatory changes that may strengthen the system
While the article may come across as being critical of the shadow banking system, it is not a call to ‘restrain’ or ‘clean’ the system in some form. Instead I am proposing that this system be made more robust so that it can grow into a healthy alternative to conventional banking system. After all, it makes sense for an economy as large and dynamic as India’s to have a thriving market for corporate debt of all forms. The shadow banking system is an integral part of such a market.
Some regulations that can address the shortcomings of this system are plainly visible from the above analysis.
1. Qualify the “open-ended-ness” of a mutual fund scheme.
Let investors understand that they may be stuck holding the underlying papers in extreme events. A start here is to publish the actual liquidity of the underlying assets of the scheme. One indicator is ‘time to fully exit’ a given instrument and the portfolio as a whole (weighted average). For g-secs, this is 1 day for most schemes. For some specific CPs, it may be a couple of days and for the most illiquid papers it is simply equal to tenor of the instrument i.e. it is held to maturity. If a scheme has ‘weighted average time to fully exit’ of more than (say) 5 days, it can be called ‘somewhat open-ended’ or ‘open-ended – category moderate’. At the very least this can be an added measure of disclosure by funds so that investors know the liquidity risk in addition to credit risk and interest rate risk.
2. Promote use of close-ended schemes for illiquid papers
Fixed maturity plans were quite popular while debt funds enjoyed definition of long-term as 1 year from tax perspective. Once that changed to 3 years, FMPs went out of fashion. However, they are ideal instruments for matching the tenor of assets and liabilities.
3. Allow gating of exits in open-ended schemes
Allow mutual fund schemes that have higher exposure to illiquid papers to limit/halt the exits for some duration after their AUM drops by more than 20% from the peak. In such a case, they can plan for exits in a more orderly way or even use the actual repayment from underlying instruments in the suspended period. This is another way of extending tenor of liabilities in tough periods. This may limit buying of such debt funds to relatively savvier investors capable of assessing and living with the gating risk – which isn’t the worst outcome!
4. Allow mutual funds to participate in central bank repo funding
This is already allowed in some of the developed markets. In India too, money market mutual funds holding government securities should be able to resort to the backstop of the central bank – at least to the extent they hold government debt and can use it for borrowing money against. The central bank can refer to the Bagehot rule here – “During a crisis, lend without limit against good collateral and at high rates”. Hence the central bank can charge sufficiently high rates to mutual funds for accessing this backstop so that it doesn’t become the norm. In any case, this can remain a crisis-only measure.
5. Control the proportion of illiquid papers in the open-ended scheme and allow spawning of FMPs from such schemes
The primary cause of the FT event is the mismatch of liquidity demand from investors and available supply of it from capital markets. To avoid this to start with, the proportion of less liquid papers could have been regulated to be below a threshold. However, that may stunt the growth of corporate debt market. Hence, to meet such a requirement, a mutual fund should be able to spawn part of its illiquid holdings into a separate FMP of a given maturity. Investors in the fund at that time would hold both the more liquid main fund and the units of the FMP. The FMP can then be listed on the exchange for trading. It would generally trade at a discount that would be based on investors’ preference for liquidity. The more liquid main fund should be able to offer partial liquidity to this FMP as much as its own liquidity allows. That would allow the fund house to offer its expertise in credit fund management while continuing to run an adequately liquid main fund.
Conclusion
The current shadow banking system in India based on debt mutual funds, NBFCs and corporate borrowers is very fragile. The ongoing crisis triggered by the suspension of six debt mutual fund schemes by FT can be used as an opportunity to strengthen the system with better regulations. Thus improved, it can be the foundation for a thriving corporate debt market in India. Such a robust debt market would price credit risk, interest rate risk and liquidity risk appropriately at all points of time and survive many a crisis intact!