Why Rajasthan government’s decision to return to old pension scheme is a fiscal disaster

 by Rajiv Mehrishi and Renuka Sane

We wrote in the Indian Express about the Rajasthan government decision to revert back to the Old Pension Scheme for its government employees.

(Published on 3 March 2022)

A Post-Pandemic Assessment of the Insolvency and Bankruptcy Code

by Renuka Sane and Adam Feibelman

It has been five years since the Insolvency and Bankruptcy Code (IBC) was enacted by Parliament and notified by the Central Government, a period of development that was abruptly halted by the Covid-19 pandemic. In general, the creation and implementation of the IBC was an impressive institutional development and a beneficial financial sector reform. As with so many aspects of society, however, the economic effects of the Covid-19 pandemic has highlighted some structural limitations of the system and has suggested ways that it might be improved going forward.

The setting

The IBC was generally designed and enacted to help promote the development of credit markets in the country and to improve the environment for foreign investors. But there was also a pressing motivation for the IBC: to help resolve a crisis with non-performing assets in the country’s banking system. This crisis was primarily caused by two unfortunate and related features of the Indian economy and credit markets. First, too many debtor firms were able to opportunistically game the legal and financial systems and evade debt enforcement. And second, banks did not have incentives to realize losses from their debtor firms and were often more inclined to extend and “evergreen” their loans. Over the years, to address the results of these problems, the RBI had initiated several schemes for banks and their borrowers to conduct debt restructuring. But these ended up being used by banks to keep loan loss provisions low, and not to resolve stressed assets. The RBI acknowledged these underlying problems in constituting a formal “Asset Quality Review (AQR)” programme in April 2015.

Furthermore, these RBI programmes did not apply to other classes of creditors, who were only authorized to use general mechanisms such as SICA, SARFAESI, and BIFR. These regimes represented a fragmented framework for resolving corporate financial distress, beset with delays, and unable to provide a quick resolution for all manner of default. They tended to be debtor-friendly, allowing defaulting debtors to maintain control over their firms and reorganize even when their businesses were faltering. Thus, the pre-IBC system – if it could called such – was widely viewed as dysfunctional and had generally failed over the years to help or force bank creditors clear their non-performing loans or to promote efficient restructurings or liquidations.

Thus, the main goal in designing the IBC was to provide creditors with a more reliable and efficient way to enforce their claims against debtors. The IBC put creditors – especially “financial” creditors – in charge of most of the important decision-making within the system. Under the Code, any creditor can initiate a case against a defaulting debtor; owners and managers of the debtor firm are then displaced by a resolution professional; and financial creditors get to vote on plans for resolution.

As many others have observed with justifiable admiration, the Code was designed, enacted, and implemented within an astonishing short amount of time. Within a year of its enactment, the Insolvency and Bankruptcy Board of India (IBBI) had started discharging its functions, and an ecosystem of insolvency professionals, lawyers, tribunals, judges, and other stakeholders had started utilizing and performing their functions in that system. Most notably, within a year of enactment, the RBI required banks to initiate insolvency proceedings against debtors representing the country’s largest NPA’s, which sent some of the largest, most intractably troubled industrial firms to the nascent system. These came to be known as the RBI-12, and accounted for almost 25% of the total NPAs in the banking system.

IBC Functioning: By The Numbers

As of March 2021, a total of 4376 corporate insolvencies had been initiated under the IBC. Most of these (41%) have been firms in the manufacturing sector, followed by real estate (20%). Of the cases completed to date, 1277 have led to liquidation of the firms, and 348 have led to successful resolution plans. But most of those liquidations were cases that had been ongoing in the pre-existing system when the IBC was enacted; of newly initiated cases, the number of liquidations and resolutions are roughly equal. The resolution plans have yielded an average of recovery of 40% for financial creditors, although this number reflects a great deal of variation in recoveries in particular cases. The IBC has also managed to keep the costs of the process low – they were, on average 0.92% of liquidation value and 0.49% of resolution value. According to RBI, proceeds from resolutions under the IBC accounted for more than half of recoveries of stressed assets in the banking system in 2018-19.

While the IBC has been a major institutional achievement, the system had been falling short of some of its express goals in the period before the Covid-19 pandemic. Policymakers had voiced concerns, for example, that the rate of liquidations is higher than hoped; recoveries for creditors in many cases have been lower than hoped; and the timelines set by the law for various actions had proven difficult to meet. Of the ongoing IRPs as of March 31, 2021, 79% have taken more than the statutorily mandated 270 days. Nearly half of the largest cases triggered at the direction of the RBI in 2017 are still ongoing, and these represent a significant portion of the NPA’s in the banking system. Delays throughout the system are due, in part, to the failure to date to create a robust system of information utilities, which were designed under the Code to provide timely and reliable information about credit relationships and defaults. The absence of these information utilities means that threshold factual disputes are slowing progress in many cases.

Moratorium Fallout

In the early months of the Covid-19 pandemic, the Indian government and regulators took a number of dramatic steps to address its financial and economic effects. The RBI, for example, allowed for a general loan repayment moratorium and eased requirements for classifying defaulted loans.Regarding the IBC in particular, shortly after the strict lockdown of March 2020, the IBBI increased the threshold for (pre-pandemic) defaults that made debtors eligible for insolvency from one lakh rupees (roughly $1,500) to one crore rupees (roughly $150,000). At that time, the IBBI also announced that the strict timelines for the restructuring process under the Code would be paused during the pandemic. On June 5, 2020, the Central Government issued an amendment to the Code instituting a moratorium on IBC cases based on defaults during the pandemic.

That moratorium was extended twice and formally ended in March of this year, just before the second wave of Covid-19 cases ground life in the country to a halt again. The primary rationales given for the moratorium were the limits on judicial capacity during the pandemic and concern that there would not be a sufficient number of resolution applicants (i.e., bidders for insolvent firms), leading to widespread and inefficient liquidation of firms in the system. Notably, the moratorium also covered debtor-initiated insolvencies. The moratorium notwithstanding, there were roughly 200 corporate insolvencies initiated last year against firms that were eligible due to pre-pandemic defaults. This represented a sizeable fraction of the number of filings from the previous, non-pandemic year.

It has not gone unnoticed that, while other countries have adopted pandemic-related modifications of their insolvency and bankruptcy regimes, India was alone in essentially shuttering the IBC for firms affected by the pandemic. This meant that the IBC was totally sidelined as part of the response to economic and financial crisis. To be sure, insolvency and bankruptcy law is only one potential tool in the overall set of responses needed to address a crisis such as the current one. But as we have seen in other countries, it can play a beneficial and sometimes crucial role in resolving or restructuring firms that face financial distress due to – or in the midst of – an external economic shock. There was clearly a need for such a tool or mechanism as a result of the effects of the pandemic; instead of utilizing the IBC, the RBI created a completely new consensual restructuring scheme.

The Shortcomings

The need for a moratorium of the IBC during the pandemic and the ad hoc RBI restructuring scheme reflect some general limitations in the function of IBC as it has developed. It has highlighted, for example, that the IBC was simply not designed or implemented to promote voluntary restructuring of otherwise viable firms with financial problems. This was due to numerous factors, perhaps most notably a skepticism of defaulting firms and loss-averse banks borne of the practical experience. Discouragement of voluntary and negotiated restructuring is built in to the system through features such as the ability of any creditor to trigger an insolvency upon a modest default, the fact owners and managers are displaced from the affairs of their firms once a case is initiated, and that owners of many firms are precluded from continuing as owners after restructuring. It has been exacerbated by the fact that the system has become exclusively a process for auctioning off firms and liquidating those firms that cannot be successfully purchased out of the system.

Some of these attributes of the system were intended in the original design, but others have emerged through amendment or practice. For example, the insolvency process under the IBC has come to require that resolution plans be exclusively in form of bids to purchase the firm. And the process has become overly focused on the overall price of “resolution” bids as compared to the actual plans for restructuring those firms’ business models and capital structure or to the distribution of proceeds among creditors. There is a general understanding among bank creditors that they should accept the highest bid rather than assess operational or management plans for firms. The Code as initially designed did not require either. Vesting decision-making authority in creditors was based on an assumption that they would be in the best position to choose plans that made the best business sense. Furthermore, the Code as initially enacted clearly allowed for the possibility that debtors would be able to offer resolution plans for their own firms – if the debtor’s plan made most commercial sense, they would be allowed to regain control of their firms. This fact is evident in the subsequent decision to amend the Code to prohibit some owners – those defined as wilful defaulters or who have recently non-performing accounts – from being “resolution applicants” under the Code and, thus, unable to make a bid for their firms.

Applying The Fixes

There are reasons to believe that these structural limitations of the IBC will be continue to hobble the system in the short- to medium-term in the aftermath of the pandemic. There is a growing realization that the IBC moratorium and other recent policies have effectively been kicking the can of financial distress down the road. Debts owed by firms and individuals throughout the country have not been forgiven but made temporarily unenforceable; many debtors will be emerging from the pandemic in a deep financial hole. This is exactly the type of scenario – widespread debt overhang among debtors who are otherwise returning to viability – for which a formal and efficient restructuring tool could be beneficial at both the micro and macro levels. But even in the longer term, a system that is effectively unavailable for firms that could benefit from voluntary restructurings is simply missing an important cog.

We therefore echo the calls of a growing group of commentators to make the IBC system more amenable to restructurings generally and voluntary restructurings in particular. We appreciate that many knowledgeable observers worry that relaxing the creditor-oriented nature of the IBC will simply open the door to all of the problems that existed under SICA and other pre-IBC regimes. We share that worry. But recalibrating the IBC can be done without returning to the status quo ante. There are various ways to make the system more serviceable for viable firms that need restructuring without making it unmanageably debtor-friendly and while also maintaining the IBC as a useful tool for resolving unviable firms. The new regulations allowing for MSME’s to obtain pre-packaged insolvencies exemplify a cautious and promising step in this direction. The process was clearly designed to provide a route for owners and managers to voluntarily utilize the IBC as a restructuring tool. Among other things, it enables owners and managers of MSME’s – even those who would otherwise be barred by section 29(a) from bidding on the firm in a normal insolvency process – to institute a reorganization while continuing to operate and own the firm, depending on the approval of two-thirds of their financial creditors.

The impact of the pre-pack option itself will be limited. For one thing, it only applies to certain MSME’s. And structurally, it requires a debtor firm to reach an agreement up front with two thirds of its financial creditors to initiate the process, without providing the debtor any additional leverage to motivate those creditors to agree. But, as others have noted, this innovation could provide a partial blueprint for modifying the insolvency process under the Code for other debtors. The key components of this blueprint include allowing owners and managers to remain in control of their firms; giving debtor firms a limited, circumscribed chance to propose resolution plans and seek creditor approval; and relaxing rules against letting promoters continue to be the owners of firms that go through the system. Such changes need not return us to the perils of SICA if creditors can still initiate an insolvency; if they retain the exclusive power to approve resolution plans; and if tribunals can review debtors’ proposed plans for feasibility. If debtors are allowed to continue to control their firms in insolvency, they should be subject to meaningful oversight and a plausible threat of displacement. And promoters could be required to contribute new capital to be allowed to continue as owners of their restructured firms, as is the case in other jurisdictions.

Changes Outside The IBC

For the IBC to promote voluntary and negotiated restructurings and to function more effectively in general, however, also depends on some critical changes in the broader financial system and the regulatory environment. For one thing, banks must make progress in developing both an inclination and the expertise to evaluate and negotiate restructuring arrangements with their debtors. This depends in some part on relaxing some of the skepticism in the financial system and in society about promoters and the causes of financial distress. While many promoters will act opportunistically and mismanage affairs, many of them will face financial distress due to external shocks and honest mistakes. For them, a restructuring tool could help return their firms to viability.

But it also depends on changes in the banking regulatory environment, which currently hampers development in this direction in various ways. It often encourages mechanistic, overly cautious approaches to addressing non-performing assets, and it fails to provide sufficient incentives to banks to be both assertive and flexible in their relationships with borrowers in distress. For example, bank employees – both public and private –are considered public servants under the Prevention of Corruption Act (POCA). As a result, they face perceived legal risks in the judgments they make about restructuring loans. In such a position, it is easier to mechanistically choose among bids rather than engage in complex negotiations with borrowers. A more consequential regulatory failure is that the RBI does not force banks to aggressively write down stressed debt. Such forbearance offers banks no incentives to attempt to address their borrowers’ distress before they need to enter the IBC and before firm value has evaporated; in fact, it effectively encourages them to engage in the ever-greening of loans that has fueled the NPA crisis.

Changes in these kinds of background legal and regulatory approaches could help improve the incentives of banks, the main creditors in the Indian economy, to be more proactive in restructuring loans (and taking necessary losses) where appropriate. That, in turn, could motivate banks to develop more expertise in restructurings and turnarounds, making it more likely that the IBC, with some of the institutional reforms described above, could serve as a useful tool for voluntary and negotiated reorganizations. Banks and firms may nonetheless still often delay and avoid employing the insolvency system, but operational creditors have the ability to initiate cases, and they have proven that they are willing to do so. If debtor firms are allowed an exclusive period to propose resolution plans, it is worth considering whether operational creditors should also be given the right to vote on those plans. Doing so might further improve the incentives of bank (and other financial) creditors to reach negotiated outcomes.

One Last Thing

As a final note, we believe it is also time to notify the Code’s provisions that apply to personal debtors. The economic and financial effects of the pandemic are creating the same hazards of over-indebtedness for individuals and households as for firms. In fact, there is evidence that lending to households has increased significantly in recent months. As consumer credit plays an increasingly important role in the Indian economy and society, there is a structural need for a process to deal with consumer over-indebtedness. But the need to recalibrate the system to make it less creditor-oriented is even more important in this context. The consequences of an involuntary insolvency for individuals can be debilitating, leading to significant social costs and deterring productive borrowing. Giving creditors the unconstrained power to approve – and thus to effectively dictate the terms of – debtors’ repayment plans will surely make the insolvency process forbidding for debtors, who will be especially hesitant to employ the system even when it is clearly in their interest, and in the social interest, for them to do so.



(This article first appeared in Bloomberg Quint, 23 July, 2021)

Applicability of the IBC to public sector enterprises: The case of Hindustan Antibiotics Ltd

In this article, Sudipto Banerjee, Karthik Suresh and I, revisit the HAL dispute and examine the position of PSEs within the ambit of the IBC. We argue that creditors of PSEs (or PSEs themselves) should be able to access the IBC. Removing PSEs from the IBC's purview may lead to delays in resolution, and may close an important route which the government could use for disinvestment.

(The article first appeared on the Leap Blog, 18 February 2020)

Isolation : A weak link in Indian public health

In this article, I argue that all four legs of the public health response -- trace, test, isolate, treat -- are weak in India. There is considerable interest in the problems of tracing and testing. There is a need for fresh thinking on the problem of isolation also. Once millions of people in India have been tested, what are we going to do with the persons who have tested positive?

(The article was first published on the Leap Blog, 29 March 2020)

Holding their breath: Indian firms in an interruption of revenue

In this article,  Anjali Sharma and I ask, How many days of liquidity cover is there, in the large non-financial firms, to be able to meet a certain threshold of minimum expenses in the absence of any revenue? 

We make four assumptions

1. A 100% sales shock for all non-financial firms. 
2. Liquid assets only include cash and marketable securities.  
3. A 50% realisation of the value of marketable securities in the book.
4. Basic core expenses required to stay alive

Our calculation is admittedly based on extreme assumptions: Zero decline in wage expenditure, zero access to fresh credit, and zero revenues for a certain number of days. More than half of the Indian corporate non-financial balance sheet is unable to hold its breath for 90 days, under these assumptions. About a quarter of the firms will not be able to handle a 30 day interruption of revenues. This highlights the incompatibility of a zero decline in wage expenditure with a sustained period of zero revenue and no fresh borrowing.

(The article was first published on the Leap Blog, 3 April, 2020)

Runs on mutual funds

The Leap Blog
12 October 2018
(with Ajay Shah, Bhargavi Zaveri)

Runs on banks

Runs on banks are to finance what supernovae are to astronomy. R. K. Narayan's book The financial expert vividly tells the tale of the chaos and misery of a bank run.

Bank runs are not random events. What makes a bank run happen is the fact that each depositor has the incentive to run when faced with a slight chance of a run developing. Robert K. Merton used runs as a motivating example of his introduction of the concept of `self-fulfilling prophecies'. In order to understand runs, we must understand the incentives of each customer.

Suppose a bank is not protected by the government or by the central bank. Suppose you see many depositors running to take their money out of the bank. Now there are two possibilities.

If you believe the bank is unsound, then it is efficient for you to stand in the queue and try to take your money out. If others do this before you, then you may be left with nothing.

Even if you believe the bank is sound, you know that a bank with illiquid assets and liquid liabilities will default when faced with a run. While you will get your money back (as the bank is sound), you will suffer the loss of time value of money and you will suffer the administrative costs of it all working out. Hence, it's efficient for you to stand in the queue and try to take your money out.

Runs on mutual funds

We know a lot about runs on banks. What about runs on mutual funds? At first blush, the simple technology of a mutual fund -- NAV based valuation, full mark-to-market, liquid assets -- seems run-proof. But in September 2018, Rs.2.35 trillion exited Indian mutual funds. Why did such an outsized exit take place? It cannot be just coincidence that many people felt like leaving at the same time.

Large exits have taken place with mutual funds elsewhere in the world also. During the 2008 crisis, the Reserve Primary Fund (with exposure to Lehman Brothers' commercial paper) witnessed a similar run-like situation. The US District Court's order directing the liquidation of the fund records how redemption requests aggregating to two-thirds of the value of the assets of the fund were received in a span of less than 48 hours immediately following Lehman Brothers having declared bankruptcy:

Date	Time	Value of redemption requests received (in USD bn)
15th Sep	08:40 am	5
15th Sep	10:30 am	10
15th Sep	01:00 pm	16.5
16th Sep	3:45 pm	40

What are the incentives that shape the behaviour of an investor in a mutual fund? How can a mutual fund industry be susceptible to runs?

Channel 1: Over-valuation can lead to runs

Suppose a mutual fund has 100 bonds that are liquid, where the true price (market price) is Rs.100. In addition, it has 100 bonds that are illiquid. The market does not give a reference price for the illiquid bond. If we tried to find out a prospective sale price, it would be Rs.50. Suppose the mutual fund claims that this bond is worth Rs.75. The true portfolio value is 10000+5000 = 15000, but the mutual fund claims the value is Rs. 17500. Suppose there are 100 units. In this case, the NAV should be Rs.150, but it is shown as Rs.175.

Over-valuation destabilises rational investors. The rational investor knows that each unit is truly worth Rs.150, but if she redeems right away, before the mistake in the NAV calculation is corrected, she will get Rs.175.

When one unit runs at Rs.175, where does the excessive payment of Rs.25 come from? It comes from the investors who did not run. This is unfair, and it creates strong pressure to run.

Channel 2: False promises can lead to large redemptions

Suppose a mutual fund has been sold to investors under the false promise of it being a safe product. In this scenario, investors do not expect fluctuations in the NAV, and believe that their investments will be shielded from turmoil in the markets. If, for any reason, this expectation is belied, then investors may get spooked by sharp falls in the NAV. This may induce large redemptions.

In the US, there was a claim that the NAV of money market mutual funds would not drop below $1. This was termed `breaking the buck'. In 2008, when the NAV did drop below $1, this caused panic and the flight of investors who had been told all along that the scheme would not break the buck.

Channel 3: Runs in an illiquid market

The Indian bond market is extremely illiquid, but even within this landscape, there is heterogeneity in the extent of illiquidity. Fund managers will be sensitive to the transactions costs faced when trading in alternative instruments, and choose the most liquid ones first.

Suppose a mutual fund has some cash in a liquidity buffer, and has 100 bonds that are more liquid, where the true price (market price) is Rs.100. In addition, it has 100 bonds that are illiquid. Suppose fair value accounting is indeed done, and we correctly value the illiquid bonds at Rs.100. The trouble is, the illiquid bonds incur large transactions costs when selling in large quantities. While there is a (bid+offer)/2 of Rs.100, in truth, when a large quantity is sold, the price realised will be Rs.90. This is an `impact cost' of 10%.

Therefore, when the first redemptions come in, the mutual fund will adjust by using cash and then it will adjust by selling the liquid bond. At first, things seem fine. But in time, the mutual fund will have to rebuild its cash buffer. It will have to get back to a more diversified and more liquid portfolio. For this, it is going to have to sell the illiquid bond, and at that time the NAV will go down.

After large redemptions, there is an overhang of selling of illiquid bonds that is coming in the future.  In this situation, investors are better off leaving early as they get the clean exits associated with the early use of cash and the early sale of liquid bonds.

Channel 4: Systemic spillovers in an illiquid market

When large redemptions take place in even one or two schemes, at first they will use cash buffers and sell liquid instruments. But when they start selling illiquid instruments, this changes the price of those illiquid instruments. Now declines in prices hit the NAVs of all schemes that hold those instruments. Through this, large redemptions on a few schemes propagate into reduced NAVs (at future dates) across the entire mutual fund industry. Prediction: In periods of large inflows/redemptions, we will get a pattern of autoregression in the mutual fund NAVs across days, across the multiple funds that hold a pool of illiquid instruments.

Rational investors anticipate this phenomenon, and have an incentive to run when they see large redemptions in even a few mutual fund schemes (and vice versa).

Runs on mutual funds are a complex phenomenon

We have shown four distinct channels through which large redemptions on mutual funds can develop:

1. Overstatement of NAV; it is efficient to leave at a higher price.
   
2. Consumers who thought it was very safe, get spooked, and leave.
   
3. Sales of illiquid securities that are pent up; it is efficient to get out before those transactions hit the NAV.
   
4. Market impact by a few schemes under stress will ricochet into NAVs of other schemes and the problem will worsen; it is efficient to get out early.
   

In India, a large proportion of the customers of fixed income funds are institutional (e.g. page 4 of this AMFI document). These customers are likely to be pretty rational in understanding problems 1, 3 and 4. Households are likely to be more vulnerable on account of problem 2.

It is interesting to see the `curse of liquidity'. When redemptions come in, mutual funds will sell their most liquid bonds first. Through this, innocent bystanders -- the issuers of liquid securities -- will suffer from price impact and a higher interest rate.

Thinking about runs on mutual funds thus requires a full view of the problems of consumer protection (if all consumers accurately understood the risks that they were taking, they would be less spooked when events unfold), financial market development (the lack of a liquid bond market) and systemic risk (channels of contagion through which disruption of some parts of finance induces disruption of other parts of finance).

Interesting recent experiences in India

While India has not seen a full blown run on mutual funds as was seen in the US in 2008, a few instances of defaults on bond repayments followed by falls in NAVs and rise in redemption requests offer useful insights.

Amtek Auto (2015): In September 2015, Amtek Auto defaulted on a bond redemption of Rs.800 crore. In the Indian corporate bond market, once a default takes place, the bond tends to become highly illiquid. The Amtek Auto bonds were held by two debt schemes of J. P. Morgan Mutual Fund.

J. P. Morgan did an unusual thing: they put a cap on redemptions. It subsequently used something analogous to a good-bank-bad-bank structure, where the scheme was split into two, and the second part held the Amtek Auto bonds, and could not be redeemed.

This did not go down well with SEBI. SEBI sought to penalise J.P. Morgan for, among other things, not following "principles of fair valuation under mutual fund norms" and for changing fundamental attributes of the scheme without giving an exit option to the investors. Nearly three years after the incident, J.P.Morgan settled the matter by paying a settlement fee of about Rs. 8.07 crore under the provisions of the SEBI Act, 1992 providing for settlement of civil and administrative proceedings.

Ballarpur Industries (2017): In February 2017, Ballarpur Industries defaulted. At the time, Taurus Mutual Fund held their commercial paper. Unlike J P Morgan's response, Taurus Mutual Fund reportedly marked down the value of the paper to zero. This is a sound and conservative strategy as it gives a bad deal to the persons who run.

Other mutual funds reportedly sold such paper to group companies or took it on their own balance sheet to shield the investor from the NAV hit.

ILFS (2018): More recently, ILFS group firms have defaulted on bonds issued by them. These bonds are present in certain mutual fund schemes. Some mutual funds have portrayed this event as a loss of 100%, while others have portrayed a 25% loss. Credit rating agencies were very late in understanding the problems of ILFS, and to the extent that credit ratings are used in computing the NAV of a mutual fund scheme, these NAVs would have been overstated.

Why might NAV be overstated?

The IFRS notion of fair market value came about first in finance, on a global scale, and much later got enshrined into IFRS. For example, in the US, under the Investment Company Act of 1940, the definition of `value' for mutual fund securities holdings is construed in one of two ways. Securities for which `readily available' market quotations exist must be valued at market levels. All other securities must be priced at `fair value' as determined in good faith according to processes approved by the fund's board of directors. Marking a particular security at a fair value requires a determination of what an arm's-length buyer, under the circumstances, would currently pay for that security.

The US SEC's framework recognizes that no single standard exists for determining fair value. By the SEC's interpretation, a board acts in good faith when its fair value determination is the result of a sincere and honest assessment of the amount that the fund might reasonably expect to receive for a security on its current sale. Fund directors must "satisfy themselves that all appropriate factors relevant to the value of securities for which market quotations are not readily available have been considered" and "determine the method of arriving at the fair value of each such security."

Supervisory strategies can be developed, to identify if the management is overstating prices of illiquid securities. As an example, imagine that there are three mutual funds who hold an illiquid bond and have claimed a certain fair value of the bond. Now imagine that one of those three sells the bond on date T. The market price obtained on date T by this fund should not be too far from the internal notion of fair value that was used by the other two funds.

It is ironic that in India, IFRS concepts of valuation have come to the non-financial sector first and the financial sector last. RBI and IRDA have explicitly resisted the adoption of IFRS. The lack of fair value accounting lies at the core of the Indian banking crisis and the concerns about the soundness of LIC.

Currently, the valuation norms prescribed by SEBI ask AMCs to value non-traded and/or thinly traded securities "in good faith" based on detailed criteria. This appears similar to the IFRS principles of fair value accounting. As an example, bonds issued by ILFS should be marked down to the prospective resale value, even if the event of a default has not yet taken place on a particular security.

There are two problems with SEBI's norms on fair value. First, it is not clear that SEBI has the commensurate supervisory strategy, to verify that mutual funds are indeed marking down securities to prospective market values. SEBI does not show supervisory manuals on its website through which we can assess its processes in this regard. When some mutual funds have marked down ILFS bonds by 100%, while others have marked down by 25%, this raises concern about the drafting of the regulation and/or the supervisory process.

Second, the SEBI-prescribed valuation norms entrench the use of credit-rating agencies for valuation by mutual funds. As rating agencies emphasise, their opinion on a security is just an opinion: ratings should not be used in the drafting of regulations. We should be skeptical about using rating agencies to override IFRS principles of valuation. For questions of valuation, the only question should be: What is the prospective price that would be obtained if this security is sold? There should be no role for the opinions of credit ratings.

We recognise that when an active market is lacking, it is very hard for anyone to figure out a notion of fair price. This is a problem ever-present in fair value accounting. E.g. when a non-financial firm has a piece of land, the market value of that land is not clearly visible. What we need to fight is not individual instances of estimation error but estimation bias. By default, the fund managers and the shareholders of the fund are likely to suffer from a bias in favour of over-optimistic portrayal of NAV. It is the job of regulators to fight the bias, not at the level of individual decisions about a benchmark price, but at the level of the expected value of the estimation error.

How can we improve truth in advertising?

When debt mutual fund investors lose money, there is a tendency to force the AMC to make good the loss. This may be driven by regulatory populism, or the temptation to improve the sales of other schemes. This is a dangerous and unviable course.

Getting the micro-prudential framework correct. Let's think about the micro-prudential regulation of a mutual fund. The fund manager is merely an intermediary who pools funds and invests them in a basket of assets, and issues "units" that represent an undivided share in such a basket. The risks in holding these assets are borne by consumers.

The balance sheet of the asset management company is nowhere in the picture, when it comes to the customer. Micro-prudential regulation in a mutual fund, therefore, is restricted to procedures for ensuring that the NAV of the fund is calculated correctly, and does not concern itself with issues of solvency.

SEBI's regulatory framework governing mutual funds, however, entrenches the notion of `safe' funds. This is inconsistent with the concept of agency fund management. For example, the valuation norms for mutual funds specified by SEBI require mutual funds to provision (that is, set aside capital) in respect of defaulted assets as under:

• Where a debt security in the mutual fund's portfolio has defaulted on an interest payment, the mutual fund must classify it as a NPA at the end of a quarter after the due date of payment. For example, if the due date for interest is 30th June, 2000, it will be classified as NPA from 1st October, 2000.
• The mutual fund must provision for the principal plus interest accrued upto the date on which the asset is classified as a NPA. SEBI prescribes a schedule for provisioning that mandates the mutual fund to provision upto 100% of the book value of the asset.

This is conceptually flawed. It is perhaps inspired by notions from banking. But mutual funds are not banks. A regulatory framework that mandates such provisioning is inconsistent with the idea that a mutual fund is merely a manager of funds, and entrenches the idea of a promised return in a debt mutual fund scheme.

If we start thinking that the AMC must pay debt mutual fund schemes for losses, then a wholly different problem in micro-prudential regulation will arise. Large AMCs today manage assets worth Rs.1 trillion on a balance sheet of Rs.0.001 trillion. The risk absorption capacity of such a balance sheet is negligible when compared with the magnitude of assets. The entire concept of a mutual fund as an agency mechanism for fund management breaks down, if investors are to have recourse to the balance sheet of the fund manager.

If we go down the route of asking mutual funds to have equity capital on their balance sheets, then this changes the very nature of the fund management business. This sets the stage for confused thinking such as increasing the minimum capital requirements from firms. In 2014, SEBI increased the minimum networth requirements from Rs.10 crore to Rs.50 crore, which has been seen as anti-competitive.

Fix the mismatch of expectations among consumers One more way in which truth in advertising is contaminated is the behaviour of mutual funds themselves.

Suppose some mutual funds dip into their own pockets when faced with a small default like Ballarpur Industries. What kinds of expectations does this setup in the minds of consumers? Do consumers then invest in mutual funds expecting that they will be protected from credit defaults? Such an expectation will inevitably be violated, when a large default such as ILFS comes along. For an analogy, if the central bank smooths the fluctuations of the exchange rate, this contaminates the expectations of the economy about the ex-ante risk embedded in exchange rate exposure, and actually causes greater harm when large exchange rate changes inevitably come along.

The only sound foundation for the mutual industry is one in which customers bear all losses. It is incorrect for AMCs to absorb the loss for small defaults, build an expectation that customers are shielded from such defaults, and not make good the promise when defaults are large. This risk needs to be communicated to the mutual fund investor at the time of investing, and through actions that are "true to label".

One final mechanism through which truth in advertising can be improved is though enhanced disclosures about liquidity. Customers need to know more about the ex-post transactions costs experienced by the fund on various instruments.

How can we reduce systemic risk spillovers?

The root cause of these problems lies in India's failure to build a bond market. We have a large debt mutual fund industry backed by a poor foundation of bond market liquidity. Even the most liquid bonds are fairly illiquid. Hence, when such selling pressure comes about, these bonds will suffer from price impact. Their prices will go down, their yields will go up. When redemptions take place, for whatever reason, yields of the most liquid bonds will shoot up. If the selling pressure is large enough, these markets will stop working.

Critical policy work on building the bond market was begun in 2015, but was rolled back. We need to get back to this important reform.

If the underlying corporate bond market is not adequately liquid, debt schemes should not promise liquidity. This promise is a recipe for trouble.

In the limit, regulators could restrict open-end schemes to very liquid instruments. The right institutional mechanisms to hold illiquid assets are closed-end funds or private equity funds, where the promise of liquidity is not made.

If open-end schemes must be offered to customers, and if they hold illiquid securities, there must be limitations on liquidity. SEBI has allowed restrictions on redemption in "circumstances leading to a systemic crisis". Specifically, it allows a mutual fund to restrict redemptions when the "market at large becomes illiquid affecting almost all securities rather than any issuer of (sic) specific security". Further, the circular provides that a "restriction on redemption due to illiquidity of a specific security in the portfolio of a scheme due to a poor investment decision, shall not be allowed". This creates considerable confusion on the situations in which mutual funds may restrict redemptions. For instance, in the current situation, it is unclear whether a mutual fund having exposure to the defaulted paper of ILFS would be allowed as it has the potential of systemic risk spillovers or whether such a restriction would not be allowed due to the poor investment decision of the mutual fund scheme.

Mutual funds should be allowed to ring fence losses to ensure that 'all investors are treated fairly', that is, when there is a run on the fund, those who choose or are unable to redeem their units do not suffer at the expense of those who do redeem. SEBI was reported to have rejected a proposal from AMFI that specifically allowed mutual funds to adopt such ring-fencing approaches.

Market liquidity is the commons

These episodes are a reminder of the importance of market liquidity. The ultimate foundation of the financial system is liquid asset markets. When asset markets are liquid, marking to market is sound, financial intermediaries work well, firms can raise resources through primary market issuance, etc. All this rests on the edifice of exchanges, instruments, derivatives, arbitrage, algorithmic trading, etc.

Liquid asset markets have the nature of a public good. Once they exist, they are non-rival (your consumption of liquidity or price information does not reduce my access to the same) and non-excludable (it is not possible to exclude a new-born child from living under their benign influence).

The very public goods character of liquid markets implies that nobody will expend effort on building a liquid market. In the political economy of finance, there are always narrow agendas which want to harm liquid markets. A steady stream of regulatory and other actions comes along, seeking to harm liquid markets. There is a tragedy of the commons, when each regulatory action pollutes market liquidity. Private persons will not mobilise to solve the financial economic policy problems that harm market liquidity. This is the role of the leadership in economic policy.

Data privacy: Too many hats for UIDAI

​The Justice Srikrishna Committee’s final report has missed an opportunity to separate the conflicting roles played by the Unique Identification Authority of India (UIDAI) by bringing the UIDAI under the proposed Data Protection Authority’s (DPA) purview.

​​The committee’s draft law (DL) defines a data fiduciary as someone who “determines the purpose and means of processing of personal data”, meaning that anyone collecting or using our data is a data fiduciary. It also distinguishes between personal data and sensitive personal data (such as biometrics), the latter having greater protections.

​​DL proposes that a fiduciary should process our data in a fair and reasonable manner that respects our privacy, process the data for specific purposes, collect only that data that is necessary for the specified purpose and seek our consent, explicit for sensitive personal data, before collecting or processing the data.
​​DL also provides for rights of access, correction, data portability to data subjects as well as the right to be forgotten. There is also a right to withdraw consent for use of one’s data. The data fiduciary is required to ensure that the data processed is complete, accurate, not misleading, updated and retained for only as long as needed for the stated purpose.

​​DL proposes four additional obligations on large data fiduciaries, ‘significant data fiduciaries’. It requires such entities to maintain accurate and up-to-date records on how it handles data, to conduct data impact assessments before undertaking any new or large-scale activity that might potentially harm us, appoint a data protection officer to meet the obligations, and get its policies and processing of personal data audited by an independent data auditor.
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How will we know that any of this is being adhered to? Towards this, DL proposes a DPA, an independent regulator overseeing the process and all data fiduciaries.

​​The UIDAI would qualify as a data fiduciary, and significant data fiduciary: it collects, stores and processes sensitive personal data and is the centralised repository of biometric data of over 1.2 billion residents and Aadhaar numbers crucial for availing welfare benefits and operating mobile phones, bank accounts and, interestingly, sending parcels overseas through the post office.
​​If DL is enacted, then the UIDAI as a significant data fiduciary would have to meet the obligations on data impact assessments, data auditing, reporting and appointment of an information officer required by law. It would also come under the purview of the regulatory authority of the DPA. UIDAI maintains the biometric data and oversees the process of authentication and thus, acts as a data fiduciary. Significantly, however, it is also a regulator: it licenses and regulates, and has the quasi-judicial powers to suspend Registrars and Aadhaar enrolling agencies. UIDAI also writes subordinate-legislation, redresses grievances and is the only entity authorised to file criminal complaints.

​​The report, however, does not seem to appreciate this distinction. It calls for more powers to the UIDAI for stronger enforcement and penal levies. This suggests that the committee does not think that the UIDAI is a fiduciary, and assumes that it will continue to play the role of a regulator while it collects and maintains extremely sensitive data of India’s citizens. This assumption is also strengthened by the fact that DL has not proposed such changes to the Aadhaar Act (unlike its suggested amendments to the RTI Act), although the report does propose specific changes.

​​We have discussed the problems of the Aadhaar legal framework including that of the UIDAI further delegating the specification of important standards/procedures to a future, undetermined time leaving the current system to function in a legal vacuum (https://goo.gl/g33vLb) and the problems with UIDAI’s accountability framework (https://goo.gl/WHHqdt). If DL is passed as it is, the DPA should assume UIDAI’s regulatory functions while UIDAI should function as a significant data fiduciary meeting all its legal obligations, amending the Aadhaar law accordingly. Such separation of the data fiduciary function from the regulatory function will bring in more accountability and transparency.

​​The next step would be for Parliament to discuss the draft bill, engaging with the relevant stakeholders and civil society. Given the immense impact that the UIDAI has on our lives, and if the Supreme Court is to uphold the constitutionality of the Aadhaar Act, one can only hope that these important issues are publicly debated and clarified.

(The post is co-authored with Vrinda Bhandari. It first appeared in Economic Times, 29 July 2018)