Opinion | The backstory of reserve bank of India’s cash window for mutual funds4 min read . Updated: 27 Apr 2020, 11:02 PM IST
A similar window was opened during the 2009 crisis to stabilize the market
In the weekend that went by, little housework got done in the homes of officials of the Securities and Exchange Board of India (Sebi), Reserve Bank of India (RBI) and some fund house leaders. On Friday, 24 April, the full impact of an announcement late the previous night by Franklin Templeton Mutual Fund was digested by the markets, regulators and investors. The fund house had frozen six of its high-yield debt funds with over ₹30,000 crore of investor money. Friday saw panicked investors, some on the advice of bank wealth managers, selling their credit funds across fund houses without a thought to how much risk they really carried. The panic threatened to spill over to other non-credit risk debt funds as well. Mutual funds have a certain calculation of how much redemption will take place on a day and have cash ready for that. But when there is a sudden rush of redemptions, funds can borrow up to 20% of their net assets to meet this redemption. What happened with Franklin Templeton MF is that even with that borrowing the sell requests piled up, leading to this first-of-its-kind decision to freeze the funds.
As Friday wound up, the writing on the wall was clear— unless there was some sort of confidence-building done in the market, the Franklin Templeton crisis will spread across debt funds with assets under management (AUM) of ₹11 trillion. Saturday and Sunday (25 and 26 April) saw hours of conferences between Sebi and some mutual fund CEOs and between RBI and banks and between RBI and Sebi officials and heads. They were trying to assess the extent of the problem and the amount of money needed. One mutual fund CEO I spoke to said that minus the Franklin Templeton portfolio, of the ₹11 trillion debt fund AUM, ₹10 trillion was low credit risk. Of this ₹1 trillion in the higher risk buckets, a quarter was in papers rated triple A (safest), half in double A plus and double A minus (quite safe) and a quarter in A and below (higher risk). Next, they totalled how much funds had borrowed from banks to meet redemption pressure. It seems that as on Thursday evening (23 April), there were four fund houses with ₹4,400 crore borrowing from banks, of which ₹4,000 crore was by Franklin Templeton. Once the extent of the problem was gauged, the coordinated cash window facility was announced on Monday morning (27 April).
RBI’s 27 April release says that banks will be able to borrow from the central bank at the repo rate, that is 4.4%, up to ₹50,000 crore till 11 May. This money can be used to lend to mutual funds and to buy bonds from them. What happened to the market was not a credit event—this means that the credit rating of the bonds held by Franklin Templeton or other funds did not fall as they had during earlier episodes like Amtech and IL&FS, but the liquidity in the market dried up. The Indian bond market is not liquid for bonds other than government and triple-A-rated. When a fund house faces an unanticipated and unrelenting redemption pressure, it begins to sell the bonds it holds. But in the absence of a liquid market, the price of the bonds begins to fall below its true value. What the RBI cash window does is that it just provides the liquidity the system needs to prevent a fire sale of assets that have not turned bad.
But why will banks pick up lower-rated bonds or lend to mutual funds when the ₹50,000 crore TLTRO 2.0 money targeted at MFI and NBFC papers was not even half used? Two reasons. One, banks may lend to mutual funds and may not buy the bonds. Two, RBI allowing banks to classify the money lent as held to maturity and not marked to market helps in not having to value bonds when there is frozen market and the price discovery is flawed. RBI is also allowing banks that lend under this window to keep such funds out of the Large Exposure Framework. Basically, this additional lending will not breach any regulatory limits.
The coordinated work by the two regulators is reminiscent of the 2009 crisis when a similar window was opened up to stabilize the market and create confidence. The mutual funds had hardly used any of the funds made available, as just the presence of the window worked to give confidence to investors. No financial firm that either takes deposits or money from investors can deal with a sudden run on the bank or mutual fund. Long-term closed-end products like Provident Fund (PF) and life insurance products do not face this redemption daily and, therefore, are out of the scrutiny of the daily net asset value. Investors should not distrust the market but understand their own risk-return appetite and then stay out of risk-bearing products if they cannot stomach it.
Monika Halan is consulting editor at Mint and writes on household finance, policy and regulation