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:
- Overstatement of NAV; it is efficient to leave at a higher price.
- Consumers who thought it was very safe, get spooked, and leave.
- Sales of illiquid securities that are pent up; it is efficient to get out before those transactions hit the NAV.
- 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.