A cooperative liquidity window for mutual funds: A debate

by Harsh Vardhan vs. Josh Felman and Ajay Shah.

Problem statement

There is a mismatch between the growth of the mutual fund industry versus the maturation of the financial markets (Shah, 2018). This generated trouble after the IL&FS default of August 2018, and will likely make trouble in the future also. Mutual funds are in an awkward place, promising liquidity to their customers but lacking a liquid bond market. Some years ago, the exchanges were getting better, and there was a path to building the Bond-Currency-Derivatives Nexus, so we could hope that progress on both paths would come along and solve the problem of the mutual funds. Now, both elements (exchanges and bond market reform) have a weak outlook. Is there a way out of this conundrum? Can a liquidity window for mutual funds be created, through which the problem of the mutual funds can be solved?

Why we need this and how it can work, by Harsh Vardhan

Indian debt mutual funds have grown rapidly over the past few years. Debt funds got a strong push after demonetisation. Currently the total assets under management (AuM) of debt funds are ~ Rs 15 Trn. There are individual debt fund schemes with AuMs of over Rs 1 Trn.

Debt funds invest their corpus in debt securities. In India there are two main classes of debt securities – those issued by the government including central and state governments and those issued by companies. Both have very poor liquidity. In the case of government bonds, while there is a somewhat liquid interbank market, a large part of the liquidity is in a single ‘benchmark’ paper which is typically a 10 year bond. When a new 10 year bond is issued, the old one ceases to be the benchmark and its liquidity drops sharply. The lack of liquidity is even worse with corporate bonds.

Most debt mutual funds promise high liquidity to their investors. For liquid and short duration funds, redemption proceeds are credited to the investor on T+1 while for most other debt funds it is T+2. MFs suffer the agony of liquid liabilities and illiquid assets. They manage this challenge through two pathways: (a) holding cash (typically less than 5% of AuM) and (b) having credit lines from banks.

There is considerable systemic risk in the Indian financial system, and situations where these two pathways prove to be inadequate. As an example, Franklin Templeton shut down six debt schemes when redemptions were unusually large and the bond market was unusually illiquid. The redemption pressure that they faced had nothing to do with their money management; it was induced by an episode of systemic risk.

In the anatomy of these recurrent debt market crises, one interesting feature is market failure in the form of a negative externality. Purely at random, when large redemptions show up at any one door, the selling that this induces drives down prices (as the overall market is illiquid and impact cost is high), which adversely impacts the NAV of all other funds. For any rational economic agent that sees the first inkling of higher outflows (either by watching flows or by looking at NAV changes), it is rational to yank all debt investments. This creates a channel through which selling by one fund induces redemptions for others.

Another way to locate these problems in the framework of market failure is to see that market liquidity is a public good. As an example, the liquidity of Nifty futures is non-rival (your consumption of liquidity does not adversely impinge on my access to liquidity) and non-excludable (everyone can access the Nifty futures market). When we build liquid markets, we are creating a public good.

All market failure is ultimately a problem of coordination between economic agents. We should look for collective action through which some of the problems of debt mutual funds can be addressed.

There are two solutions going around, for this problem of bond market illiquidity, which just don’t make sense. One strategy is for regulators to demand that mutual funds hold more capital. Mutual funds are not balance-sheet based entities and the journey of trying to amplify their equity capital requirements is conceptually wrong. Another strategy is for the central bank or the government through any other agency, to run a liquidity window for mutual funds. When the full consequences of this play out for mutual funds, it is likely to leave them worse off.

Is there a way out of this jam? I believe we can establish a Cooperative Liquidity Window (CLW), built by mutual funds for mutual funds -- with a small involvement of the state -- which can help solve this problem. For the people who are too used to state leadership in such things, we should point out that the Bank of England played this kind of function -- liquidity support for distressed banks -- for centuries as a purely private organisation; it was only nationalised in 1946. During the great depression in the US in the 1930s, J P Morgan, founder owner of the eponymous bank, orchestrated a bail-out of the American banking system through co-operative efforts of larger, stronger banks. These experiences are food for thought, and the design proposed here draws on this history.

For such an emergency liquidity support mechanism, we should establish five conceptual objectives:

• It should use no public money.
• There should be an extremely low amount of state coercion involved, in getting some MFs to participate in the CLW, and no role for the state in terms of regulation, management, appointments, or rule-making of the CLW.
• The governance of the mechanism should be within the AMCs that participate in it; it should operate as a self regulatory organisation.
• The capital to set up and operate the mechanism should be provided by the participants; it should operate as a mutual co-operative; rules of access to the mechanism should be defined by the participants.
• It should be only an emergency liquidity support system. The criteria for defining an emergency, and the extent of support that can be provided to individual entities, should be defined by members as the by-laws of the mechanism.

How would the proposed CLW work?

1. The participating AMCs would create a vehicle by contributing to the equity of the vehicle. The vehicle could be set up as a trust or any other legal form that minimizes transaction costs.
2. Some members would be coerced by SEBI (the largest firms adding up to perhaps 75% of the category AUM) and others would be voluntary participants (those who would like to benefit from its services even if not forced by SEBI). Apart from this, there would be no role for the state power in the CLW, in any fashion.
3. The equity contribution of each MF should be determined by its debt fund corpus. For example, all MFs with debt fund AuM of over Rs 1 Trn might contribute Rs.5 Billion, those with an AuM of Rs 0.5 Trn to 1 Trn might contribute Rs. 3 Billion, and so on. The CLW governance must write the specific rules of equity contributions.
4. The CLW would leverage up and create a corpus that supports a securities repurchase (repo) operation in the event of stress.
5. When a member AMC faces severe redemption pressure (way beyond what is deemed normal by the members collectively as defined by the governance rule of the CLW) it would pledge its eligible debt securities to raise short term liquidity. This would be akin to a bank accessing the repo window in the event of a run.
6. This window would also accept liquidity from members like a normal repo window.
7. The rules regarding the extent of liquidity support provided, the tenure, the bid-ask spread, acceptable securities as collateral and hair cuts, etc. would all be defined by the members collectively.
8. The CLW would operate as a not for profit entity or provide a modest return on equity to the member shareholders.

Currently there are ~45 AMCs in India. If we assume that 40 of them participate, each contributing an average of Rs 1 billion of equity capital, we would have Rs.40 billion of equity capital in hand. Assuming 4x leverage, the resources of the organisation would be Rs.160 billion. It is easy to go to much higher values.

The CLW should support participating MFs only in dealing with liquidity issues and not credit risk issues. This should be enshrined in the governance and operating rules of the CLW. Considering that the CLW will be managed by the AMCs themselves, who are all deeply informed players, it is reasonable to assume that they will be able to differentiate between liquidity and credit issues, Further, at a security level, the CLW will determine eligibility of securities and haircuts applicable. This will ensure that even in providing liquidity support, credit issues are not ignored. The rules of operation of the CLW should be well known, ex ante, so all the participating MFs face a predictable environment.

Let us simulate how the Franklin Templeton crisis might have played out, if this CLW was in place. The issues faced by Franklin Templeton’s shuttered debt funds schemes were purely liquidity issues: Over the last 18 months or so, they have returned upwards of 90% of the AUM at the time of shutting the schemes. Further, the return on these funds during the time was comparable with other funds in the same asset class. As the Franklin Templeton crisis was a liquidity crisis and not a credit crisis, the CLW would have been in play to support the liquidity crisis at Franklin Templeton. With illustrative assets of Rs.160 billion, it would have had the financial depth to deal with this situation, where all six affected funds put together had a total AUM of about Rs. 250 billion.

This design is not a substitute for a deep and developed bond market. A liquid market for securities is always the best solution to deal with any liquidity issues. But we face a problem today: We have a situation where the debt mutual funds corpus has grown very significantly and yet the bond market, especially the corporate bond market, remains very illiquid. The CLW is a mechanism where enlightened self interest can create a cooperative which helps the sector deal with a dangerous liquidity challenge.

In my proposal, there is only one use of state power: I feel SEBI should force large debt funds adding up to (say) 75% of the industry AUM to be members of the CLW, and force non-members to communicate this lack of membership in their customer-facing communications. The justification for this use of state power lies in the extent to which this would help reduce systemic risk (innocent bystanders being adversely affected in the next mutual fund crisis). This coercion addresses the free rider problem, where any one MF may derive benefits from the more stable mutual fund / bond market system, but try to be stingy in not paying for this stabilisation. Apart from this, I propose there should be no state involvement / control / regulation of the analysis, design, staffing, rule-making or operation of the CLW.

All members would have the self interest of making the facility work well -- as they are both owners and customers -- and they would thus exert governance. This is a problem where a cooperative solution works well. There is no market failure in the working of the CLW, and thus no role for regulation or any other involvement of the state.

There is one limitation in this design. The CLW will not be adequate if there is a full fledged financial crisis, such as what was experienced in 2008. In that case, the CLW would become one more element of the financial system that would have to be analysed in the crisis management at MOF.

There is no solution which can cover up for the lack of a bond market, by Josh Felman and Ajay Shah

Bond mutual funds are facing a serious dilemma. On the one hand, they promise investors liquidity, the ability to withdraw money at short notice. But on the other hand, they hold assets that are largely illiquid and difficult to sell. As a result, they face a mismatch between what they promise and what they can actually deliver.

Investors typically pay little attention to this mismatch, because most of the time it isn’t apparent. That’s because on most normal days, the investors who want to withdraw their money are more than counterbalanced by the many investors who are putting their money into the funds. It is only when this balance is disrupted, when a large proportion of investors “run” to take their money out, that mutual funds must sell their assets and the liquidity mismatch is revealed (Sane, Shah, Zaveri 2018).

Of course, banks face a similar mismatch problem. They, too, promise that depositors can withdraw funds easily, even as they hold assets (loans) that are even more illiquid than bonds. But in the case of banks there is a firewall against runs, namely the deposit insurance provided by the Deposit Insurance and Credit Guarantee Corporation. With this insurance, depositors know that their deposits are always safe. Accordingly, they have no incentive to rush to banks to withdraw their money, even if they find out that their bank’s loans have turned bad.

Could a Cooperative Liquidity Window (CLW) provide a similar firewall for debt mutual funds? At first blush, it seems like it would. After all, if the problem is that bonds are illiquid, then it seems logical to create a window that would allow funds to exchange bonds for cash. Moreover, the CLW proposal has some particularly attractive features. It would be a private initiative, involving no public money; and it would be employed only in emergencies, reducing the risk that it would distort financial markets. It avoids state failure by having no state involvement, apart from coercing large mutual funds (MFs) to become members.

But we see difficulties in translating this concept into a working liquidity facility. Consider the following problems with the proposal:

• The illustrative corpus – Rs 160 billion – is relatively small, about the size of a single mutual fund group (such as Franklin Templeton). So, if several groups get into trouble at once, there won’t be enough liquidity to go around. In our thinking about the CLW proposal, we should think of something more like Rs.0.5 trillion of dry powder.
• The proposal envisages that lenders will be willing to purchase Rs 120 billion of CLW debt. Would they really be willing to lend so much money to an unknown institution engaged in the risky activity of buying illiquid debt? And even if they did, what interest rate would they charge?
• Assuming that lenders charge a relatively high rate of interest, how will the economics of every day operation of the CLW work out? In most years, its assets will simply be sitting in safe but low-yielding government securities, so it will suffer from a negative cost of carry. That means it will need to make compensating large profits on its occasional liquidity activities, by buying debt at very low prices and selling at high prices.

Let’s assume optimistically that these problems can somehow be overcome. We think the proposal still won’t work, because it has an important flaw: it is based on the premise that mutual funds facing runs are merely suffering from liquidity problems. But things are usually not this simple. Most runs involve credit risk issues, which means that there is a danger of defaults, which could saddle the CLW with large losses. And this makes all the difference. To be concrete: we don’t agree with Harsh’s relatively sanguine assessment of the Franklin Templeton story.

Runs on mutual funds follow a standard sequence. Initially, investors find out that a large bond-issuing firm is in serious trouble. In response, they start examining the portfolios of their mutual funds. And when they find the funds that are heavily exposed to the teetering firm, they run. This is precisely what happened in the case of Franklin Templeton. This firm invested aggressively in risky assets: even its “safe” Ultra Short mutual fund invested more than one quarter of its portfolio in assets rated A or below, rather than the AAA assets that such funds would normally hold. In addition, Templeton invested heavily in zero coupon bonds issued by Yes Bank. So when financial markets turned risk averse and Yes Bank ran into trouble, investors fled the Templeton funds.

In restrospect, it turns out these investors were correct: there was indeed credit risk. It is now almost two years since Templeton shut six of its funds, and the 300,000 investors in these funds still haven’t received all of their money back. Even if investors are reimbursed eventually for their full nominal amounts, they have suffered an opportunity cost. Inflation will have eaten away at the real value of their money, and they will have lost the opportunity to use the funds to meet last year’s expenses (such as Covid hospital bills) or make other investments. In particular, they were unable to place this money in the stock market, which has nearly doubled since withdrawals were frozen in April 2020.

The complexity of correlations and asymmetric information about credit and liquidity risk means that the proposed CLW will run into three problems:

1. It could distort the incentives of mutual funds. Right now, mutual funds face market discipline. They know that if they invest in risky, illiquid bonds, they will get into trouble if investors panic and demand their money back. So most mutual funds – unlike Franklin Templeton – try to confine their purchases to safe, relatively liquid bonds. Precisely for this reason, most funds were able to survive the runs on Templeton largely unscathed.

This discipline could disappear if a liquidity window is established. In this case, mutual funds will feel more free to buy risky, illiquid bonds. In fact, they might try to buy as many such bonds as possible. After all, risky bonds carry higher interest rates, so mutual funds that buy them will be able to advertise higher returns. And if things go wrong, these funds will always be able to pass the problem onto the CLW.

Of course, they will not be able to transfer all their risk, since they have contributed to the equity capital of the CLW. For example, if they own 10 percent of the CLW, they would have to bear 10 percent of any losses faced by the CLW. Still, they might be able to pass on 90 percent of any potential losses. And this is enough to distort incentives.

So, the CLW will try to stop such behavior, by limiting the types of debt they will buy. But this will not be easy.

2. The CLW will find it difficult to use rules or discretion to determine what types of debt are eligible for the facility. If the CLW tries to use rules, that is to define the types of debt that they will buy, firms will employ ‘financial engineering’ to create debt that nominally conforms to the rules but in fact remains highly risky. This was how the US wound up in a financial crisis in the mid-2000s: because firms created synthetic bonds that were rated AAA but were actually highly risky. Closer to home, there are also examples of bonds that were deemed safe – like the AAA-rated bonds issued by ILFS – that nonetheless ended up defaulting.

If the CLW consequently eschews rules and says instead that it will handle episodes using case-by-case discretion, users will fear that they cannot rely on the CLW, since such an approach would mean that other members could veto their attempt to unload their bonds to the facility.

We request the reader to not envision peaceful times, when some trades are taking place and spreads are fine, but instead to think of times when spreads are high, recent trades have stale prices, and a pall of fear hangs over the market. Consider a situation like late 2008, when bond prices were plummeting. At that time, buying bonds was considered a foolhardy act, comparable to ‘catching a falling knife’. Would a consortium of mutual funds really have the courage to intervene in this situation?

It is important to recall that the shareholders of the CLW are, themselves, bond market traders. They are the ones refusing to buy the bonds at any price on their own books – that is why the bonds are illiquid! So why would they allow their agent (the CLW) to do this? Consider the calculation of the other firms. If the CLW purchases the bonds, and the bonds default, the cost will have to be borne by the members of the cooperative. In contrast, if the CLW doesn’t purchase the bonds and the mutual fund is forced to shut down, the other firms might even benefit. Recall how the rest of the financial system `ganged up’ against LTCM in 1998, as they stood to gain from declining prices of LTCM’s positions.

3. Even when the CLW is willing to purchase bonds, it will not be easy to agree on a price. When bonds are illiquid, their price is not known to anyone. The distressed mutual fund will plead for a high price – and it will have a say in the running of the CLW. But other shareholders would object, as they would not want to suffer losses. So the Board of the CLW will work themselves into a tizzy trying to agree on a sale price.

Let’s assume the majority on the Board gets to decide the price.They will face an inherently difficult problem. Because the bonds are illiquid, the Board will need to guess the true value of the bonds on offer. And because the CLW would be running with an elevated leverage ratio, the consequences of guessing too high would be disastrous. At a 3:1 debt-equity ratio, a 30 percent fall in the price of the CLW’s assets would wipe out the entire equity capital. So, the CLW will need to offer a low price.

These three problems would haunt the CLW. It might freeze up with decision-making paralysis precisely at the times when decisive action is most required. Alternatively, it might proceed, but with excessive caution. It might purchase only select assets, meaning that many mutual funds facing runs would find the liquidity window closed. And even where the CLW was willing to purchase their assets, it is likely to offer a low price, which would prove ruinous to already-stressed MFs. These features interfere with the stated function of the CLW.

Many people remember stories from the Panic of 1907, where one person -- J.P. Morgan -- was the buyer of the last resort. This mechanism worked because Morgan was a self-interested profit-maximising individual who made a decision to use dry powder. He drove a hard bargain and purchased assets very cheaply, and turned a tremendous profit. He took enormous risk in the process, for he could have gone bankrupt himself. And, it could easily have been that the demand for liquidity insurance was bigger than his balance sheet, in which case his intervention would have gone badly wrong. For each J.P. Morgan who is celebrated for a 1907 event, there are many others who failed at various moments in history. We dream that a CLW will be able to think and act like J.P. Morgan, but its shareholders + board + management would find it impossible to have the entrepreneurial and risk-taking acumen of an individual. This is perhaps why we don’t see such a co-operative liquidity window in the world today.

A final point. We have stayed within the construct of no state intervention other than forcing MFs adding up to 75 percent of category AUM to become members. We fear, however, that when faced with the difficulties described above, the Indian state will not hold back even though there is no market failure. Once this happens, the familiar litany of state failure would commence.

We see this debate as a special case of a general principle. An economic policy strategy that addresses the surface symptoms is unlikely to work; the scope for financial engineering in public policy is very small. For a policy to succeed, it needs to engage in a root cause analysis, to address the underlying economic problem. If the problem is that investors are running from bond funds because they are inherently illiquid, then the only way to solve this problem is by reducing the mismatch between what these funds promise and what they can actually deliver. And that requires some fundamental financial reforms.

Hence, we would argue that the future of Indian finance remains along the strategy of the Financial Sector Legislative Reforms Commission (FSLRC). Once this is done, the need for a liquidity window will gradually fade away.

Bibliography

Mutual funds with feet of clay. Ajay Shah, Business Standard, 22 January 2018.

Runs on mutual funds. Renuka Sane, Ajay Shah, Bhargavi Zaveri. The Leap Blog, 12 October 2018.

Sudden Rise of the Floaters

by Rajeswari Sengupta and Harsh Vardhan.

The first two months of 2021-22 have witnessed a remarkable new trend in the corporate bond market—a sudden rise in the issuance of floating rate bonds or “floaters” and the use of the 91-day treasury bill yield as the reference rate in these bonds, instead of the yields on dated government securities (G-Secs).

We conjecture that one possible reason behind this new development could be an increase in the perception of interest risk on the part of the bond market participants. This in turn may have been a result of the active yield curve management undertaken by the Reserve Bank of India (RBI). If indeed dated government bonds such as the 10-year G-Secs have lost relevance as benchmark securities then this can lead to serious mispricing of risk in the economy, an unintended consequence of the RBI’s bond market intervention.

An interesting development in the bond market

Over the three-month period from April to June 2021, about 7 percent of the total corporate bond issuance of Rs 1.02 trillion consisted of floating rate bonds. While this percentage looks small, it is important to keep in mind that for the previous ten years or more, the share of floating rate bonds in the total issuance of corporate bonds has been less than 1 percent.

It is also important to note that the firms issuing these bonds and the investors investing in them are not a new class of issuers and investors. They are the same issuers and investors who were issuing and buying fixed-rate bonds until recently. In particular, 100 percent of the floating rate bond issuers now are non-banking finance companies (NBFCs) who were earlier issuing fixed rate bonds, and the investors are the same mutual funds and banks who were investing in fixed rate bonds earlier. This could imply that their behaviour has now changed due to external developments. It is as if the bond issuers and investors have suddenly developed a taste for floaters.

Corporate bonds are typically issued with a maturity of more than one year, along with a coupon, which is the rate of interest to be paid on the bond. Most bonds have a ‘fixed’ coupon—the rate of interest on the bond is decided at the time of issuance of the bond and remains fixed over the life of the bond.

This rate is a function of two factors – (i) the prevailing risk-free interest rate for the maturity matching that of the bond, and (ii) the credit risk spread that is added to compensate the investors for the default risk associated with the issuer.

The risk-free reference rate is ideally the interest rate on the government security of similar maturity. The credit spread is the function of the credit rating of the issuer. For example, if a AAA-rated issuer wants to issue a 5-year maturity corporate bond, then the risk-free reference rate will be the rate for a 5-year government security (let’s say 5.7 percent). If the credit spread of the AAA-rated issuer is an additional 100 basis points (1 percent), then the bond will be issued with a fixed coupon of roughly 6.7 percent. Note that this rate will apply to all the future interest payments by the issuer until the bond matures even if the underlying risk-free rate changes. This means that the investor in this bond is taking the interest rate risk. The secondary market price of these bonds reacts to changes in the underlying interest rates – the bond prices fall if the risk-free interest rate increases and bond prices go up if the risk-free rate decreases.

In the case of a floating rate bond, the main components of determining the coupon remain the same—a reference rate and a credit risk premium. The crucial difference is that the reference rate is no longer fixed but changes over time. Hence, these bonds are referred to as ‘floating’. The coupon on these bonds clearly specifies the reference-floating rate.

If the bond in the example cited above were a floating rate bond, then the coupon on it will not be a fixed rate of 6.7 percent. Instead, it will be the rate on 5-year government security at the time of interest payment plus 1 percent. In other words, for a floating bond, the applicable interest is computed at the time of payment of interest. If the 5-year government security rate moves up by 0.5 percent in a year then the interest rate payable will become 7.2 percent. The investor in such a bond is more protected from interest rate risk and the prices of these bonds in the secondary market fluctuate much less with movements in interest rates.

In the last two months, floating rate bonds worth Rs 70 billion have been issued in the corporate bond market, almost entirely by private companies. Overall, bonds worth Rs 793 billion have been issued by the private sector including NBFCs. The floating rate bond issues in these two months thus represent around 10 percent of private sector bond issuance.

An interesting feature of these floaters issued in the last two months is that all of them have used the yield on 91-day treasury bills (T Bills) as the reference rate. Notwithstanding the fact that these corporate bonds have maturities ranging from 2 to 4 years, yields on dated government securities (i.e., G-Secs with maturity of more than 1 year) have not been used as a reference.

What might explain this sudden preference on the part of the issuers and investors for these floating bonds?

What might be going on?

One possibility could be a heightened perception of interest rate risk. Bond investors might be harbouring the belief that the interest rates on dated G-Secs are unlikely to remain at their current levels. As discussed earlier, issuing floating rate bonds is one way to mitigate interest rate risk. This raises the next question – why would the perception of interest rate risk suddenly go up now?

We conjecture that this could be a result of the manner in which the RBI has been managing interest rates in the government bond market. The Covid-19 pandemic presented the Indian economy with an unprecedented challenge. A combination of falling tax revenues and rising expenditure on account of fiscal stimulus resulted in a massive increase in the fiscal deficit of the government, and a corresponding rise in government borrowing from the bond market. In 2020-21 the consolidated government borrowing was a whopping Rs 21.5 trillion and the planned borrowing for 2021-22 is roughly Rs 19.6 trillion. The overall government debt to GDP ratio is roughly 90 percent, the highest ever.

The RBI on its part has taken multiple steps to ensure that interest rates are kept low in the bond market so that the government’s cost of borrowing remains under control. It has allowed several primary auctions of G-Secs to devolve on primary dealers and has even canceled auctions when it did not receive bids at rates that were low enough. In addition to its standard open market operations (OMOs), it initiated the Operation Twist program whose objective was to bring down interest rates at the long end of the yield curve and push up rates at the short end. This meant that the RBI was buying long-dated G-Secs and selling shorter maturity bonds.

In March 2021 the RBI launched a program called the G-SAP wherein for the first time it pre-committed to buying a specific amount of G-Secs. These bond market interventions are mostly aimed at capping the interest rate on the benchmark 10-year G-Sec at 6 percent. As a consequence of these actions, the RBI has ended up owning a substantial amount of the 10 year benchmark government bonds (link).

It is possible that bond investors believe that the RBI will not be able to suppress the interest rates for too long, and the rates will rise sharply and suddenly. This could be either because of the large volume of G-Secs the government needs to issue to finance its deficit or because of growing inflationary concerns in the Indian economy (CPI inflation has exceeded the upper limit of 6 percent of the RBI’s targeted inflation band in both May and June 2021), or because of external factors such as rising inflation in the US.

This is akin to a spring that has been forcefully compressed but can bounce back anytime. If the rates suddenly go up, holding fixed coupon bonds will lead to losses, as explained earlier. This increased risk perception might be one possible explanation as to why the investors now prefer floating rate bonds.

Arguably, another unintended consequence of the steps taken by the RBI to lower the long-term G-Sec yields and suppress the organic evolution of the yield curve in response to market forces may have been that the bond market participants have lost confidence in the yield curve.

In the past whenever inflation went up, 10-year G-Sec yields would also go up, implying a positive correlation between the two variables. The underlying idea is that rising inflation is usually followed by a tightening of the monetary policy stance which in turn leads to higher long term bond yields.

For instance, figure 1 below plots the 10-year G-Sec yield alongside CPI (consumer price index) inflation from 2004-05 to 2013-14. This was a period of high and rising inflation. CPI inflation went up from 3.8 percent in 2004-05 to more than 10 percent in 2012-13. Concomitantly, the 10- year rate went up from 6.6 percent in 2004-05 to more than 8 percent by 2012-13.

Figure 1: CPI Inflation and 10year G-Sec yield, 2004-05 to 2013-14

But recently this correlation seems to have broken down. We can see this clearly in figure 2, which plots the two series using monthly data, focusing on the period from March 2020 to June 2021. CPI inflation began rising from May 2020 onward. It consistently breached the 6 percent upper limit of the RBI’s targeted inflation band during the period April-October 2020, increasing from 5.8 percent in March to 7.6 percent in October. More recently it went up from 4.2 percent in April 2021 to 6.3 percent in June 2021.

Figure 2: CPI Inflation and 10year G-Sec yield, March 2020 to June 2021

However, this time around, rather than increasing, the 10-year G-Sec yield actually fell from 7.5 percent in April 2020 to 5.8 percent in May, since then holding more or less steady around 6 percent. These developments suggest that G-Sec rate might be distorted by the RBI’s interventions, which in turn might explain why some investors are turning to the T Bill rate as a preferred reference rate.

Other explanations are, of course, possible. The rise of floaters could also be a result of companies expecting interest rates to come down, in which case they would not want to issue long-term debt at higher rates. This however seems unlikely. Given that inflation continues to be a concern, interest rates are more likely to go up rather than down, and sooner or later RBI would need to start normalising the surplus liquidity situation that the financial system is currently in.

Alternatively, floaters could be issued if the private sector is tapping a new class of investors, who are interested in buying bonds but do not want to run any interest rate risk. But the issuers of and the investors in the floaters are exactly the same entities that were participating in fixed-rate bond transactions earlier.

Finally, it is also possible that the funding requirements of the NBFCs (the sole issuers of floating rate bonds right now) have undergone some changes which might have increased their preference for these bonds.

Conclusion

We are observing an interesting new development in the corporate bond market. The rise of floating rate bond issuances by private NBFCs, and the use of the 91day T Bill rate as the reference rate seem to indicate a change in the preferences on the part of both issuers and investors.

We conjecture that one reason that might explain this development is the intervention in the bond market by the RBI to control G-Sec yields. Specifically, it is possible that the RBI’s persistent interventions have caused some market participants to lose trust in the yield curve. This possibility needs to be explored further in the future.

If there has indeed been an erosion of credibility in the yield curve, then this would be a serious problem. The yield curve is a fundamental construct in a market economy, as it defines the interest rate structure that is used to price debt. As a result, if the yield curve is distorted, then interest rate risk is being mispriced. The associated misallocation of resources could prove to be costly, damaging the economy just as it struggles to recover from the Covid crisis.

Harsh Vardhan is Executive in Residence at the Center for Financial Studies (CFS) at the SP Jain Institute of Management and Research. Rajeswari Sengupta is an Assistant Professor of Economics at the Indira Gandhi Institute of Development Research (IGIDR). The authors thank Josh Felman and an anonymous referee for their useful suggestions.

The Indian corporate bond market: From the IL&FS default to the pandemic

by Rajeswari Sengupta and Harsh Vardhan.

The banking sector is the most important financial intermediary in India's debt market. Over the last few years the bond market has emerged as an alternative to the banking sector especially for the top rated firms. This trend has been pronounced ever since the banking sector started reporting high levels of non performing assets. Figure 1 below shows the flow of commercial credit in India from various sources and highlights the growing relative importance of bond issuance especially from 2015 onwards.

The bond market has faced two big shocks in recent years: (i) the default by IL&FS (Infrastructure Leasing and Financial Services Limited) in September 2018, followed by other relatively low-impact shocks due to problems in companies such as DHFL (Dewan Housing and Finance Limited) and IndiaBulls Housing Finance as well as Yes Bank, and (ii) the outbreak of the Covid-19 pandemic in India since March 2020. As a result of these shocks the risk perceptions in the bond market have gone up. In this article, we take a look at changes in the risk perceptions in the corporate bond market especially in the ongoing context of the pandemic and ensuing economic slowdown. We also highlight the asymmetry in the risk perceptions of the markets towards private sector corporate bonds vis-a-vis public sector unit (PSU) bonds and discuss the likely implications of changes in the risk perceptions, for the future funding model of non-banking finance companies (NBFCs).

Figure 1: Flow of Commercial Credit in India (Source: RBI)

Measuring risk perception

The most important metric for assessing risk perception in the bond market is the credit spread which is the difference between the yield of a corporate bond and of a government security of comparable maturity. Highly rated bonds (with ratings of AAA and AA) are traded relatively actively and their yields reflect changing perceptions of investors regarding the riskiness of these bonds. Movement over time of credit spreads on corporate bonds is therefore a good indicator of the bond market's perception of risk.

We look at the credit spreads of AAA rated bonds of 3 years and 5 years maturity from April 2018 to June 2020. The data is sourced from Bloomberg. The bonds in our data are separated into 3 categories - NBFCs (non-banking finance companies) and HFCs (housing finance companies), private corporations and public sector undertakings (PSUs), which may include public sector NBFCs such as Power Finance Corporation (PFC) and Rural Electrification Corporation (REC). The figures 2 and 3 below show the evolution of credit spreads for these three categories of bonds for the two specific maturities.

The IL&FS default

Figure 2: Credit Spreads on 5 Year AAA Paper (Source: Bloomberg)

As we see from figure 2 above, prior to September 2018, the credit spreads on the NBFC, private corporate and PSU bonds were fairly stable, between 50 and 100 basis points for the 3 year paper and between 40 and 60 basis points for the 5 year paper. In the rest of our discussion we focus on the credit spreads on the 5 year paper. The pattern is more or less the same for the 3 year paper, only the absolute levels of credit spreads are different.

Figure 2 shows that credit spreads on NBFC AAA paper of 5 year maturity nearly doubled between September 2018 and November 2018 and reached 160 basis points by February 2019. This shows that the IL&FS episode that unfolded in the 3rd week of September significantly enhanced the risk perception of the bond market regarding all top rated NBFCs.

After a small dip, the spreads went back to around 140-150 basis points by July 2019 and stayed at this high level, with some fluctuations, till November 2019. During this period, crisis in other NBFCs (such as the Dewan Housing and Finance Limited (DHFL)) as well as in Yes bank, added to the overall risk perception of the bond market. This is reflected in the credit spreads remaining high one year after the IL&FS default.

Private corporate and PSU bonds' credit spreads also widened in the aftermath of the IL&FS default, but not by the same magnitude as the NBFCs. The IL&FS default triggered a liquidity crunch primarily for the NBFC sector. The corporate sector experienced spill over effects owing to a rise in risk aversion in the bond market.

While in the pre IL&FS default period the spreads of all three categories of bonds were closely bunched together, the difference between them began increasing from October 2018 onwards. The difference was particularly acute between the NBFC and private corporate bond spreads on one hand and the PSU bond spreads on the other hand especially in the second half of 2019. This is despite the fact that these bonds were all rated AAA. This reflects the implicit government guarantee enjoyed by the PSU bonds.

The government and the RBI took several actions to deal with the ensuing crisis in the NBFC sector. Government appointed a new Board for IL&FS. RBI took several steps including open market operations to inject liquidity into the system, reducing the risk weights on bank lending to NBFCs, instructing banks to disburse sanctioned but undisbursed credit to NBFCs etc.

These eventually resulted in enhanced credit flow to the NBFCs which reduced the credit spreads in the later part of 2019. For both NBFCs and private corporate sector, the spreads declined by about 50 basis points to settle at about 100 and 50 basis points respectively. These spreads, especially for the NBFCs, were still higher than pre-IL&FS episode but much lower than their peak. We see a similar dynamic with the 3 year maturity bonds as well as shown in figure 3 below, except the absolute levels of the spreads were different.

Figure 3: Credit Spreads on 3 Year AAA Paper (Source: Bloomberg)

The Covid-19 outbreak

Just as the bond market was recovering from the shock of IL&FS default followed by crises in DHFL and Yes bank, the Indian economy got hit by another massive shock in the form of the ongoing Covid-19 pandemic. Credit spreads in the bond market began rising sharply from the middle of March once again reflecting growing risk perceptions. Figure 2 shows the increase in the spreads around the time when the nationwide lockdown was announced on 24 March.

For both NBFC and corporate bonds, the spreads rose by about 30-40 basis points between February 2020 and April 2020. For both categories of bonds the credit spreads reached their peak in the first half of May, close to 180 basis points for NBFCs and 170 basis points for the corporate bonds. The peak of the credit spreads during the pandemic has so far been higher than the peak reached in the aftermath of the IL&FS default episode.

Spreads on PSU paper also went up, but by a smaller amount. The average spread on these bonds in March and April was only 30-35 basis points. The difference between the credit spreads on NBFC and corporate bonds on one hand and PSU bonds on the other widened significantly to about 100 basis points. The large gap in spreads for bonds of the same ratings is worth noting. Similar to the post-IL&FS period, this too is a reflection of the market's perception of implicit government guarantee to the public sector units.

The impact of policy actions on credit spreads

The sharp rise in credit spreads of NBFC and corporate bonds in April 2020 could be attributed to the announcement by the RBI to grant moratorium on loan repayments for all borrowers in order to alleviate the financial stress triggered by the pandemic and the lockdown. Following this announcement, NBFCs had to offer moratorium to their borrowers but at the time it was not clear whether they themselves would also receive a moratorium from banks on their repayment obligations.

In the second half of May, the government announced a package to boost the economy. This included Rs 20 lakh crore of 'benefits' and effectively entailed an outlay of around Rs 3 lakh crore for 2020-21. RBI also adopted several policy initiatives such as cutting the policy interest rates aggressively and establishing new long term targeted repo operations (T-LTRO) that would provide 3 year funding to banks under a repo arrangement. RBI made the repo arrangement `targeted' so as to ensure that the funds raised by the banks were made available to the NBFCs.

These policy actions increased the credit supply to all issuers. Consequently, by the 3rd week of June, the credit spreads on both NBFC and corporate bonds came down from their respective peak levels of mid May by about 50 basis points.

However, the RBI and government actions notwithstanding, the credit spreads for NBFCs and private corporate sector continue to be substantially high. In fact the spreads in June 2020 were similar to the spreads in December 2018 in the aftermath of the IL&FS default. For PSUs the spreads have come down to around the same levels that prevailed before the IL&FS crisis.

This shows that the bond market remains concerned about the riskiness of the corporate sector and the NBFCs. PSUs on the other hand, benefit from implicit government guarantee. The significantly lower credit spreads they are experiencing in the time of the pandemic reflect a `flight to safety' by the bond investors.

Credit spreads and funding costs

As we interpret the bond market data, it is important to understand the difference between credit spreads and funding costs. Credit spreads going up does not necessarily mean that the cost of funding for the issuer is going up. Cost of funding for a company that raises capital in the debt market depends on the market determined yield on the security it issues This yield on debt consists of two components: risk free rate and credit spreads. RBI's monetary policy impacts the risk free rate but not the credit spreads. Credit spreads reflect the premium that the investor charges over and above the risk free rate, taking into account the inherent riskiness of the underlying bond.

Since the IL&FS episode, the risk free rate has been coming down steadily due to the actions by the RBI such as reduction in the policy interest rates (repo and reverse repo rate) and large scale open market operations to inject liquidity in the financial system. Figure 4 below depicts the yield on 5 year and 3 year government securities from the April 2018 to June 2020 period.

Figure 4: Government Securities Yield

The 5 year risk free interest rate has come down from about 8.4% in September 2018 (before the IL&FS episode) to about 5.5% in June 2020 indicating a decline of 300 basis points. The 3 year risk free interest rate has declined even more to about 4.5% over this period, a decline of nearly 350 basis points.

Since RBI's monetary policy does not affect the credit spreads, the impact of policy action on the actual cost of funding will not be the same as the reduction in the risk free rate. If risk aversion in the market goes up, then investors will demand higher price for the credit risk which will result in rising credit spreads. Thus, the net cost of funding for an issuer may decline to a lower extent compared to the reduction in the policy rates.

This is what has been happening since the IL&FS episode. Risk free rate has been declining but owing to high risk aversion, credit spreads have remained elevated. As a result, funding costs of companies have not come down by as much as the risk free rate. This implies that in an environment of high and rising risk perception such as the ongoing Covid-19 period, the effectiveness of policy rate cuts will be constrained.

The widening gap between the credit spreads on PSU debt versus private sector points to lower risk perception for PSU entities which are perceived to have implicit sovereign guarantees. The combined effects of rising risk perception, widening gap between credit spreads of identically rated issuances and reduction in the policy interest rates would mean that the debt market will skew towards government owned issuers who might experience the greatest reduction in funding cost.

Conclusion

Bond market credit spreads provide important information about the risk perception of an important class of investors. Sustained high credit spreads (compared to long term average levels) suggest elevated risk perception and imply heightened risk aversion. Specifically, it also points to the role that individual episodes of corporate defaults and the associated policy responses (or lack thereof) play in shaping risk perceptions.

Wide spreads between bonds of the same ratings issued by private companies and those owned by the government clearly indicates a strong perception of the implicit government guarantee enjoyed by public sector companies. This raises important questions as to whether the debt of government owned companies should be treated as a part of government's debt.

Finally, economic recovery in India in the post Covid-19 period will depend crucially on the flow of credit in the economy. The economic package recently announced by the government depends largely on the financial sector. Nearly 70% of the 'benefits' of Rs 20 lakh crore in the package are expected to be routed through the financial sector. In a recent article we discussed the rise in risk aversion in the banking sector. With both the banks and the bonds markets showing high levels of risk aversion, growth of credit may be less than envisaged in the package. This may dilute the overall effectiveness of government's monetary and fiscal policy actions.

Harsh Vardhan is an Executive-in-Residence at the Center for Financial Studies and an Adjunct Faculty at the SP Jain Institute of Management and Research, Mumbai. Rajeswari Sengupta is an Assistant Professor of Economics at IGIDR, Mumbai.

Coincidences in investment newsletters, fund managers and bellwether constituences

by Ajay Shah.

Burton Malkiel's design of a newsletter scam

In his famous book, Burton Malkiel offers the following idea.

1. Start 16 newsletters. In 8 of them, scream for a year that Nifty will go up, and in 8 of them, do the opposite.
2. At the end of year 1, you have 8 successful newsletters. Close down the losers. Now repeat this, with 4 forecasting up and 4 forecasting down.
3. At the end of year 2, you have 4 successful newsletters, shut down the others.
4. At the end of year 3, you have 2 successful newsletters.
5. At the end of year 4, you are solid gold: you are holding one newsletter which correctly timed the market for 4 years in a row. Now make a lot of money selling subscriptions to this newsletter.

While this is a neat design of a scam, the world is actually, inadvertently, running something like this. A large number of newsletters are born every year. Some of them are lucky, they forecast the market correctly, and they stay alive. The losers tend to shut down.

At every point in time, you see a pool of successful newsletters. This need not imply that they have forecasting capabilities. It could just be survivorship bias at work.

Fund management

This same idea would work in fund management. You could start 16 funds, and at the end of 4 years, you would be holding 1 fund with a remarkable track record. This is possible even if you have no ability to forecast asset prices at all.

Once again, the world is actually running such a system. A large number of money managers spring up all the time. When the bets don't work out, the organisation collapses. The survivors stay in the game.

The world is initiating much more than 16 funds. Thousands of fund managers take a stab at the trade. It is not surprising that at any point in time, we see five or ten of them with five or ten years of a successful track record. While some ability may exist in the world, there is certainly a simple process of survivorship bias going on, which generates a few fund managers with a good track record.

Bellwether constituencies

Suppose you have 500 constituencies, and suppose all election outcomes are roughly 50/50. That is, there are exactly two parties and they each win about half the seats. Suppose that in truth, the outcome of each constituency is completely random and it is just like tossing a coin.

At the end of one election, you have 250 constituencies where the winner of the overall election won.

At the end of two elections, you will have 125 constituencies which were with the winner for two elections in a row.

At the end of three elections, there will be 62. At the end of four elections there will be 31.

This tells us that if we see about 30 constituencies in India, where the winner in each of these constituencies was the ruling coalition that came out of the Lok Sabha elections for 1999, 2004, 2009, and 2014, this might just be simple randomness at work. There may be nothing special about these `bellwether constituencies'.

Movement on the law for the Resolution Corporation

by Suyash Rai.

Capitalism without bankruptcy is like Christianity without hell.
- Frank Borman

On June 14th, the Union Cabinet approved the proposal to introduce a Financial Resolution and Deposit Insurance Bill, 2017 ("the FRDI Bill"). This is an important step forward for a critical component of the overall strategy of India's financial sector reforms. Shaji Vikraman has insight on this in the Indian Express. In this article, I look deeper into the concept of the resolution corporation, why it matters, how we got to this milestone, and what comes next.

The slow unfolding of the banking crisis reminds us of the fragility of our financial system. The financial system, especially the banking system, is generally disaster-prone. On one hand, financial firms can make mistakes and experience losses. In addition, there is a link between problems of the economy and hardship in financial firms. When an economic downturn happens, the value of business activities declines, and this induces losses upon financial positions. We need to build a financial regulatory apparatus which will reduce financial fragility. This involves three main elements of machinery : micro-prudential regulation (which aims to push the failure probability of each financial firm to a desired value), systemic risk regulation (which aims to reduce the probability of a disruption in the overall financial system, and have tools to respond to such a disruption when it does arise) and resolution (a specialised bankruptcy process for most financial firms). At present, in India, we have weaknesses on all three elements.

Consequences of a weak resolution system

When micro-prudential regulation works well, the failure probability of financial firms is at a low level chosen by the relevant financial agency. The failure probability is not zero. Failure of inefficient firms is essential for `creative destruction'. The process of failure of inefficient firms, and the shift of capital and labour to efficient firms, is essential for productivity growth. The question is: How can we make the failure of financial firms orderly?

The failure of financial firms can often be quite disorderly. Unlike real sector firms, many financial firms manage a large amount money belonging to households and businesses, with only a small amount of capital brought in by their owners. Banks in India typically have leverage of 18$\times$ to 20$\times$, which means that their balance sheet size is 18 to 20 times the amount of equity capital. Such leverage is never seen with real sector firms. When the firm gets into trouble, there is clamour by the creditors who want to see a fair and efficient process through which they get some of their money back. Matters are more challenging with some financial firms which are so large and complex that their failure could induce instability in the financial system.

An orderly failure is one where a) the consumers either get their money back quickly or continue to get services without any significant inconvencience, and b) the stability of the financial system is not threatened. If we are not able to obtain orderly failures in the financial system, this has many adverse consequences:

• Consumers of failed financial firms suffer. As an example, in India, many cooperative banks fail every year. In spite of high entry barriers, larger institutions also fail (e.g. Global Trust Bank in 2004). Consumers lose money in these failures. These bad experiences make consumers wary of engagement with the financial system, and increase the share of gold and real estate in their portfolios.
  
• Financial stability is threatened, because even if one systemically important financial firm fails, the entire system could be destabilised by a messy, long-drawn bankruptcy process. This forces government to bail out such financial firms. So, a financial crisis ends up having a fiscal consequence.
  
• When faced with the possibility of harm to consumers, and threats to financial stability, governments get cold feet in situations of firm distress. They are then prone to bail out financial firms using taxpayers' money. We in India are familiar with this story. Public sector banks are routinely recapitalised with public funds to ensure they do not fail. This is almost never a good use of public money.
  
• Regulators sometimes respond to these problems by setting up entry barriers, which harm competition and economic dynamism. They justify the every day harm to competition on the grounds that this averts harm to consumers, risks to financial stability and the fiscal cost of bailouts.
  
• Financial firms suffer from moral hazard, and take greater risks. At its worst, financial firms obtain supernormal profit from these two interlinked channels: the certainty of being bailed out and the lack of competition.
  

A system that ensures quick and orderly resolution of failed financial firms can help avoid these outcomes. The system should be such that government, financial firms and consumers believe that the failures will be orderly. The present system of resolution in India is inadequate.

First, it mostly empowers the respective regulators (eg. RBI for banks) to do the resolution. Since regulators give the licenses and are supposed to ensure safety and soundness of the firms they license, they tend to be tardy in acknowledging their mistakes. This regulatory forbearance leads to delays in recognition of failure, which increases the costs of resolution, and may lead to losses for consumers and increases risk to stability of the financial system. There is a conflict of interest between micro-prudential regulation (achieving a target failure probability for a financial firm) and resolution (gracefully closing down financial firms which are nearing failure).

Second, the present system gives very limited powers of resolution. The powers that are given are: forced mergers/amalgamation, and winding up. Some of the other powers, such as bail-in (discussed later), are not available.

Third, even these limited powers are not enjoyed over many of the financial firms. For example, regulators do not have resolution powers over public sector scheduled commercial banks and regional rural banks.

Fourth, the way the system is structured, a bankruptcy resolution can take years, sometimes even longer than a decade. This is partly because the regulators do not have powers to take timely resolution action.

The Financial Resolution and Deposit Insurance Bill

Indian policy thinking on this began in the RBI Advisory group on reforms of deposit insurance, 1999, chaired by Jagdish Capoor.

This slumbered until we got to the Financial Sector Legislative Reforms Commission, chaired by Justice BN Srikrishna, which worked from 2011 to 2013. In its full design of Indian financial regulation, it recommended a Resolution Corporation.

In 2014, a Working Group of Ministry of Finance and Reserve Bank of India, co-chaired by Shri Arvind Mayaram and Shri Anand Sinha, also recommended a resolution capability for financial firms.

In 2014, the Ministry of Finance constitued a Task Force for the Establishment of the Resolution Corporation, under the chairmanship of Shri M. Damodaran, to work out the plan for establishing the Resolution Corporation. This was part of the two-part creation of task forces for building the new institutions required in the FSLRC architecture, which came about as four task forces followed by one more.

The budget speeches of 2015-16 and 2017-18 announced a plan to draft and table a Bill on resolution of financial firms. In September, 2016, a draft of the Bill was placed in public domain for comments.

On June 14th, the Cabinet approved the proposal to introduce a Financial Resolution and Deposit Insurance Bill, 2017 ("the FRDI Bill") in Parliament. The FRDI Bill, when enacted, will create a framework to ensure that failure of financial firms is orderly. It will establish an independent Resolution Corporation tasked with resolving failed financial firms. The Corporation will also subsume the deposit insurance function presently performed by the Deposit Insurance and Credit Guarantee Corporation.

This Bill stands at the intersection of two long-term reform projects: 1) financial sector reforms, of which bankruptcy resolution of financial firms is an integral part; 2) bankruptcy reforms, of which financial firm resolution is an integral part. So, this Bill moves both these projects forward, and is an important building block for an efficient system of capital allocation in India.

FSLRC had envisioned a separation between the resolution corporation, which would apply for most financial firms, and the bankruptcy code, which would apply for the remaining financial firms and for all non-financial firms. The Bankruptcy Legislative Reforms Commission (BLRC), which drafted the Insolvency and Bankruptcy Code (IBC), worked with this scheme. IBC does not cover financial firms, unless the Central Government notifies certain financial firms to be covered under that law. Many types of financial firms, especially firms handling consumer funds and firms that are critical for financial stability, require a specialised resolution mechanism. For firms handling consumer funds (eg. banks, insurance companies), the process under IBC is not suitable, as a large number of small value consumers will find it difficult to invoke that process. The processes of IBC are designed for creditors who are firms, not individuals. For systemically important financial firms (eg. central counterparties, larger banks), a creditor-led resolution process under IBC is not suitable, because what is at stake is not just the interest of creditors but the stability and resilience of the financial system. Hence, for such financial firms a specialised resolution regime is required. The FRDI Bill will create such a specialised resolution regime.

What is resolution?

In the world of financial firms, resolution complements regulation. Regulators and the Corporation are expected to work in tandem, with the regulators focused on maintaining financial health and, when a firm gets into trouble, pushing for its recovery. The Resolution Corporation will take over and resolve a firm after recovery efforts have failed. Although the version of the Bill approved by the Cabinet is not yet in public domain, based on the version that was released for public consultations last year, the framework is divided into four stages.

First, when the financial firm is healthy, the respective regulators will monitor the firm and work to ensure it continues to stay healthy. At this stage, the Resolution Corporation will only get information indirectly through the regulators. Substantive powers to monitor the firm or to take any other action with respect to the firm will not be available to the Corporation.

Second, once the financial firm starts deteriorating, the respective regulator will attempt recovery. At this stage also, only the regulators will continue to have substantial powers over the firm.

Third, if the recovery efforts fail, and as the financial firm get close to failure, the Corporation will get substantial powers to instruct the firm to improve its resolvability and prevent actions that may erode the values of assets available for resolution. At this stage, the role of regulators is restricted.

Finally, when the firm fails, the Corporation will take charge and resolve it. Resolution typically means selling the failed financial firm, as a whole or in parts, to another financial firm via a competitive bidding process. However, resolution could also involve other instruments. For example, the firm could be "bailed-in", which means that the rights of and obligations to creditors may be written down to recapitalise the firm from within. Bail-in typically includes converting some junior debt into equity, but may also include writing down other types of claims. This is the opposite of a bail-out, wherein outside investors rescue a borrower by injecting money to help service a debt. Finally, liquidation may be a tool used for resolution.

There is a certain degree of tension and potential conflict between the Regulators and the Resolution Corporation. This is a healthy check-and-balance. Resolution works as a check on regulatory incompetence and forbearance. Both sides will need to be mature, respect the role of the other, and coordinate.

The idea of a specialised resolution regime for financial firms is well-accepted globally. The US has had a resolution system for banks for more than 80 years. The scope of this system was extended after the financial crisis of 2008. There have been more than 600 bank failures in US since the crisis. In this time, there has been not been even one bank run in the US, because depositors trust the resolution system to work. Why the crisis happened in the first place is another matter, which is beyond the scope of resolution. Resolution comes into play only after regulation fails, and the occurrence of crisis resulted from regulatory failure, among other factors.

Many other countries have put in place comprehensive resolution systems. These include: all European Union member states, Switzerland, Australia, Canada, Japan, Korea, Mexico, and Singapore. Many jurisdictions have ongoing or planned reforms to resolution regimes. These include: Australia, Brazil, Canada, China, Hong Kong, Indonesia, Korea, Russia, Saudi Arabia, Singapore, South Africa, Turkey.

Next steps

We are still a few years away from having a full-fledged resolution regime. Now that the Bill is going to the legislative branch, it remains to be seen what version of the Bill eventually gets enacted. If the essential features of a good resolution regime are diluted in the final version, the chances of success will be low.

Even after the Bill gets enacted, it would still take some time to build an independent and competent Resolution Corporation. Since this capability currently does not exist in the system, it will have to be cobbled together, and then strengthened over a period of time. Consider the example of human resource strategy. There are many models out there. While the Canadian authority works with fewer than 100 employees, the US authority has more than 10,000 employees. The Corporation could choose to run a tight ship, and rely on contractual work to scale up capacity in times of crisis, or it could choose to build a large organisation that is able to, on its own, deal with a crisis. Similarly, given the skill sets required to do this job, the Corporation will have to think innovatively about attracting top talent within the constraints of a government agency.

The Task Force on Establishment of the Resolution Corporation, led by M. Damodaran, has done considerable work that lays the groundwork for constructing the agency. The implementation of their project planning needs to commence immediately, so that the delay between enacting the law and enforcing it can be minimised.

It will also take our governance system some time to get used to this kind of a system of taking over and resolving a failed financial firm in a decisive and quick manner, as opposed to the present approach of allowing things to linger on. If things do go right, there are many potential benefits of this reform.

 

The author is a researcher at NIPFP.

IRDAI’s commission notification hikes total compensation for insurance intermediaries

by Monika Halan.

On 14 December 2016 the insurance regulator, the Insurance Regulatory and Development Authority of India (IRDAI), notified revised commission rules for both life and general insurance. Titled ‘IRDAI (Payment of Commission or Remuneration or Reward to Insurance Agents and Insurance Intermediaries) Regulations, 2016’, the new rules have raised overall payments in the insurance industry to agents and intermediaries. The notification has come 11 months after an exposure draft that proposed changes in existing rules. The draft was open to public comments. The author helped the team at NIPFP to draft a response to the insurance regulator that argued against raising upfront commissions and payments as it encourages mis-selling, churning and causes losses to investors. A blog on the draft can be read here. The final regulations have been notified after consultation with the Insurance Advisory Committee and will come into effect from 1 April 2017. IRDAI has not given a reason why it needed to rethink the payment structure in the insurance industry. Nor has it given a reason for the change in the manner of payment and the quantum of payment. It has mandated a board-approved written policy for payments of intermediary compensation.

I will examine the changes in payouts in the life insurance industry and not the general insurance industry in this blog. Examining high upfront costs in India’s life insurance industry is important because these have been identified in two government committee reports (Swarup Committee and Bose Committee) as one of the reasons for mis-selling of insurance products in India. Several papers (this, this and this) have documented mis-selling of such products in the Indian market and the money lost by investors. The IRDAI regulation is important to analyse because it has increased the total payouts in the first year of the product at a time when other regulators are reducing upfront costs. The capital market regulator had made the mutual fund product zero front commission in August 2009 and in 2015 had capped upfronting of trail commissions (that come out of the annual expense ratio) at 1% of the investment. The National Pension System (NPS) already has low front costs that are more in the nature of a transaction cost.

The Regulations

There are four changes in the new regulations.

1. Change in intermediary categories. Currently, there are five categories of intermediaries: agents, corporate agents, insurance brokers, web aggregators and insurance marketing firms. The notified regulations break up the market into three categories of distributors of life insurance products. Agents, intermediaries with more than half their income coming from insurance, and intermediaries with less than half their income coming from insurance. Agents represent one insurance company and are individuals. Intermediaries include corporate agents, insurance brokers, web aggregators and insurance marketing firms.
2. Change in nomenclature of intermediary payments. Currently, all intermediary payments are called ‘commissions’. The new rules mandate that agent payments will be called ‘commission’, while intermediaries’ sales commissions will be called ‘remuneration’.
3. Addition of a payment category. A new payment category has been introduced to compensate agents and intermediaries called ‘rewards’. A reward is an amount paid, directly or indirectly, as an incentive by the insurer to agents and intermediaries. Rewards seek to formalise informal (which were illegal thus far) payments made by insurance firms to agents and intermediaries. IRDAI believes that agents need to be rewarded to account for benefits such as gratuity, term insurance cover, various group insurance covers, telephone charges, office allowance, sales promotion, gift items, competition prizes and such other items. Intermediaries need rewards to compensate for services such a risk analysis, gap analysis, plan design, predictive modelling, data management, infrastructure, advertisement and such other items, including any additional incentives by whatever name called. All agents are eligible for rewards that are fixed at a maximum of 20% of the first year commission that the agent collects. Not all intermediaries are eligible for rewards. Only those who earn more than half their income from the insurance business are eligible for rewards, which are the same as that for agents. Others are not. In effect, IRDAI has legalised what were illegal payments in the industry.
4. Change in the compensation structure. The new rules have changed the existing commission structure in three ways.
1. Higher commissions for pure risk products. IRDAI has hiked commissions for pure risk policies as compared to policies that bundle investment and insurance across both single premium and regular premium products. Pure risk policies insure just the life of the policyholder. If the policyholder does not die, no money returns to him. Bundled policies combine life insurance cover with investment. These come in two variants. One, unit linked insurance plans (ULIPS) that are transparent, marked to market products that work like mutual funds with a crust of life cover. Two, traditional plans that are opaque products, do not disclose a net asset value but give either an assured investment return or an indicative payout number. These products invest largely in government securities of both the centre and the states. Further, there are two kinds of policies according to periodicity of premium payment. Single premium policies, which need funding once and stay alive for the duration of the policy tenure. And regular premium policies, which need to be funded each year till the premium paying term ends and can have tenures of between five and 100 years. The changes are in Table1 and Table 2.

Table 1: Pure risk gets more commission

Table 1a: 1st year commission on regular premium policies

	Existing 1st year commission for agents1	New 1st year commission for agents and intermediaries
	(%)	(%)
Pure risk	35/402	40
Bundled 3	35/402	35/40
1 For brokers the numbers are 30% in year one for all policies with premium paying term of 10 years or more
2 35% for firms more than 10 years old and 40% for firms less than 10 years old. Today, more than 90% of the market is made of firms that are over 10 years old, therefore the 35% commission number is effective
3 For a premium paying term of 12 years or more. Commissions range from 15% to 33% for premium tenures between 5 and 11 years

Table 1b: 1st year commission on single premium policies

	Existing commission for agents 1	New commission for agents and intermediaries
	(%)	(%)
Pure risk	2	7.5
Bundled	2	2
1 For brokers the numbers are 2% of the premium

2. Higher renewal commission on regular premium policies. On each renewal the intermediary gets a ‘renewal commission’. These rates are now higher than before for both pure risk and bundled plans, though pure risk gets more than bundled plans.

Table2: Renewal commission on regular premium policies rise

For agents and brokers	Existing commission	New commission
	(%)	(%)
Pure risk	51	10
Bundled	51	7.5
1 Currently, 3rd year and subsequent premiums get 7.5% commission. Year 4 onwards it is 5% commission on renewal.

3. Introduction of ‘rewards’. The impact of adding rewards to the commissions in the first year are captured in Table 3a, 3b, 3c and 3d.

Table 3: Total payouts on life insurance policies from 1 April 2017

Table 3a: Maximum first year payments on regular premium pure risk life insurance policies

For pure risk cover policies	Maximum commission on 1st year premium	Reward as % of first year commission	Total 1st year payment of Commissions + Reward
	(%)	(%)	(%)
Agent	40	20	481
Intermediary > half income from insurance	40	20	482
Intermediary < half income from insurance	40	0	402
1 Total first year commission currently is 35/40% depending on age of insurance firm
2 Total first year commission currently is 30% for a premium paying term of 10 years or more

Table3b: Maximum first year payments on regular premium bundled life insurance policies

For bundled policies (insurance + investment)	Maximum commission on 1st year premium	Reward as % of first year commission	Total 1st year payment of Commissions + Reward
	(%)	(%)	(%)
Agent	35	20	421
Intermediary > half income from insurance	35	20	422
Intermediary < half income from insurance	35	0	352
1 Total first year commission currently is 35/40% depending on age of insurance firm
2 Total first year commission currently is 30% for a premium paying term of 10 years or more

Table 3c: Maximum payments on single premium pure risk life insurance policies

For pure risk cover policies	Maximum commission on 1st year premium	Reward as % of first year commission	Total 1st year payment of Commissions + Reward
	(%)	(%)	(%)
Agent	7.5	20	91
Intermediary > half income from insurance	7.5	20	91
Intermediary < half income from insurance	7.5	0	7.51
1 Total commission currently is 2%

Table3d: Maximum payments on single premium bundled life insurance policies

For bundled policies (insurance + investment)	Maximum commission on 1st year premium	Reward as % of first year commission	Total 1st year payment of Commissions + Reward
	(%)	(%)	(%)
Agent	2	20	2.41
Intermediary > half income from insurance	2	20	2.41
Intermediary < half income from insurance	2	0	21
1 Total commission currently is 2%

What do these changes mean?

Post these changes, from 1 April 2017, the peak rates of payouts to agents and intermediaries will go up to as high as 48% in the first year, from the current levels of 35% or 40% depending on the age of the insurance firm. IRDAI has not given a reason for making changes to the compensation structure of the intermediation industry in insurance. Section 52(2) of the draft Indian Financial Code (Volume Two) of the Financial Sector Legislative Reforms Commission Report requires that all regulators should first publish a draft of the regulations to be made. This draft should be accompanied by a statement of objectives. The statement of objectives lists out the need for new regulation and the cost and benefit analysis of the proposed changes. The financial sector regulators, including IRDAI, have agreed to implement some of the recommendations that do not require legislative action. These actions can be read in the Handbook on Adoption of Governance Enhancing and non-legislative Elements of the Draft Indian Financial Code. Carrying out a cost benefit analysis for a new regulation and making it public is one of such actions. IRDAI did bring out a draft regulation on 13 January 2016 that was mentioned earlier, but there was no cost-benefit analysis or rationale for increasing commissions. Read the analysis of what IRDAI had proposed.

What’s good and what’s not

The new rules are good in parts, but IRDAI has let go of an opportunity to reduce mis-selling in the life insurance market in India. Some parts of the regulation are in the right direction but fail to address the larger malpractice issues; one rule is outright harmful.

1. Raising commissions for pure risk policies. Life insurance is a difficult concept to understand and the sales effort to sell life insurance needs a higher incentive than selling an investment product where a return is expected. India is a poorly insured country because life insurance is sold as an investment product with a thin covering of a life cover. Agents prefer to sell the bundled products because they generate a higher commission value than a pure risk plan. Therefore, giving a higher commission to a pure risk plan as compared to a bundled plan is a good step, but these remain still too high at 40% of the first year premium. To transition the market to pure risk plans, IRDAI could have reduced commissions on bundled products instead of keeping them at 35% of the first year premium. Two government committees have recommended that investment products go zero upfront commission and move to a full trail model (links to the reports are above in para two). The capital market regulator has already implemented these recommendations in mutual funds.
2. Raising renewal commissions. A long term financial product needs to be funded each year. When faced with very high first year commissions and significantly lower subsequent commissions, the incentive structure for agents gets skewed towards stopping old policies and selling new ones. Keeping policies alive is a big problem in the life insurance industry that sees very high rates of lapsation – or discontinuation of a long term plan in the first five years. The persistency (the number of policies that stay in business after the first year) rates in life insurance are very poor, with the industry average of 61st month (5-year) persistency of just 44% in FY15 for Life Insurance Corporation that accounts for over 70% of the industry. The private sector numbers are worse. Two largest private sector firms saw poor persistency levels, with ICICI Prudential Life’s 61st month persistency in FY2015 at just 16.7% and HDFC Standard Life’s at 31.78%. These numbers are from IRDAI’s Handbook of Statistics 2014-15 that can be seen here on page 211. One way to deal with this issue is to reduce front commissions and move to a trail heavy compensation model. The capital market regulator has successfully implanted this with no harm to the market. In 2009, the capital market regulator banned upfront commissions that go from investor’s money. In 2015, it banned even ‘upfronting’ of trail commissions beyond 1% of the investment. In fact, the move to a trail based model has raised investor confidence reading to a systematic investment pipeline of Rs 4,000 crore a month into mutual funds. IRDAI is right when it raised renewal commissions in the industry, but wrong because it has kept the upfronts high.
3. Introducing of ‘rewards’. Introducing a new head for payments in the first year that essentially formalises informal payments that breached the commission caps of IRDAI is a surprising regulatory action. It is common knowledge in the insurance industry that the exiting commission caps are regularly breached. A look at IRDAI orders corroborates this where the regulator finds many companies paying out commissions to agents and brokers under many heads, including skill building, promotions, office expenses. An 8 January 2017 Final Order from IRDAI fined HDFC Standard Life for hiding foreign junket costs as ‘skill building’. It does look like the regulator has attempted to formalise what were earlier informal (and therefore illegal) payouts by the industry to the intermediaries. Post the introduction of ‘rewards’ in the first year, the peak payout rate will hit 48%. IRDAI says that intermediaries must be paid these rewards for the benefits they need to be given, including sales promotion, gift items, office expenses, competitions, for data management, infrastructure, advertising and so on. But it is worth asking the question: aren’t the commissions paid meant to take care of such costs? Why does it need an extra head to reward agents and intermediaries for getting the first year business? It is very surprising that a regulator, instead of curbing illegal payments has actually gone ahead and legalised them.

What could IRDAI have done?

IRDAI could have implemented the recommendations of the two committees and reduced upfront commissions, moving to a full trail model. The problem with raising compensation in year one of a long term product has been flagged by multiple research papers and regulators. High front commissions and payouts are go against regulatory learning across the world where high front commissions are linked to investor churning, mis-selling and sharp sales practices. To raise intermediary payouts in the first year in an overall market that has seen reduction in costs is surprising. Had IRDAI hiked the upfront payouts with tighter rules on persistency and claw backs, there could have been an argument for raising compensation. Perversely, in a 2014 Guideline to all CEOs of inurance companies, IRDAI diluted its earlier guideline for stricter persistency targets. It said:

1. Renewal of Individual Agency License and Corporate Agency License will not be subject to meeting the Persistency Rates as stated in the above referred Guidelines/Circulars.

2. All Life Insurers are required to have their own company specific persistency criterion for renewal of Individual and Corporate Agency from 1st July 2014.

With no regulatory cost on poorer persistency, the economic signal of raising first year commissions and payouts is to continue with the hit-and-run sales process. Claw back of front commissions is another way that globally insurance companies ensure a minimum persistency rate, but IRDAI is silent on this. By pushing policy holder interest onto Boards of companies, while raising overall payout rates, the regulator has let the fox into the chicken coop and told the fox to be a good boy now.

 

The author works in the area of consumer protection in finance. She is Consulting Editor Mint, Consultant NIPFP, and on the Board of FPSB India.