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The structure the central bank is using comes with its own set of challenges. (Mint)
The structure the central bank is using comes with its own set of challenges. (Mint)

RBI and mutual funds, rather than banks, should lead in MF rescue plan

  • There is a market for good corporate papers, but liquidity is badly needed for high-risk papers
  • The structure the central bank is using comes with its own set of challenges.

There was a collective sigh of relief on Monday when Reserve Bank of India said it has created a liquidity window for the troubled mutual fund industry. But the structure the central bank is using comes with its set of challenges. The lending will happen through banks, who can borrow cheap from RBI and buy investment grade corporate bonds from mutual funds.

There is already a market for good corporate paper, and the facility is intended primarily for funds that hold high-risk paper, where liquidity has dried up.

Borrowing trouble.
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Borrowing trouble.

But the banks may well give the opportunity to make a decent spread a pass, given that the fairly high credit risk will pass on to its own books. If banks end up using the facility to borrow cheap and buy good paper, it doesn’t really help achieve the intended purpose either. And then there is the conflict of interest issue, where banks could be tempted to help out mutual fund companies within the group, and leave others in the lurch.

Given these concerns, it makes sense to consider an alternative model.

Last month, the US Federal Reserve announced a Secondary Market Corporate Credit Facility to support the corporate bond market. This was done by creating a special purpose vehicle (SPV) with an equity infusion of $75 billion by the Fed. The SPV could leverage upto a 10:1 ratio, which means it can buy bonds worth upto $825 billion in all.

The Fed retained BlackRock Financial Markets Advisory (BlackRock FMA) as a third-party vendor to serve as the investment manager for this facility. In other words, the bonds would be bought at valuations determined by BlackRock FMA.

If the SPV ends up buying bonds worth $825 billion, and they are eventually sold at, let’s say, $500 billion, the Fed’s equity will first get wiped out and then it will take another large haircut on its loans it extended to the SPV. This structure makes sense, because in uncertain times such as these, it is the responsibility of the sovereign to stabilize the markets. “Only the sovereign can take on the tail risk that the bottom could fall out of the economy. Banks can’t be expected to do it," says J.R. Varma, professor of finance at Indian Institute of Management, Ahmedabad.

So clearly, RBI expecting banks to take on this risk misses the point by a mile.

A moot question is who will bring in the equity in the Indian context. “It makes sense to have the mutual funds themselves take equity in such an SPV. This can be done by applying a haircut of, let’s say, 10% on the fair value of the securities they sell to the SPV. This will generate liquidity for 90% of the portfolio," says Varma. Of course, investors may eventually end up making returns on the 10% left with the SPV as equity, depending on the eventual sale price of the bonds.

Depending on what is the fair value determined by the independent valuation firm, funds and their investors may need to live with a sizeable haircut. But it’s only fair that mutual funds and their investors who are desperate for liquidity are willing to pay this price, besides the additional haircut that works as an equity contribution for the SPV. In the current structure, banks may end up paying a price, which is odd.

And considering that they are really trying to avoid ending up in the situation Franklin Templeton Asset Management (India) Pvt. Ltd finds itself, it may be a small price to pay.

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