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?
- 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.
- 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.
- 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.
- The CLW would leverage up and create a corpus that supports a securities repurchase (repo) operation in the event of stress.
- 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.
- This window would also accept liquidity from members like a normal repo window.
- 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.
- 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:
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.
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.
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.
