Over the past few days, Ajay Tyagi, chairman of the Securities and Exchange Board of India, and his senior colleagues have been evangelizing the attributes of the corporate bond market. There seems to be a sudden urgency to their exhortations. These appeals are curiously timed, too, given that Tyagi may be looking for a second term and the market for debt will be crucial for the many state-owned and private companies cranking up operations after the lockdown is fully lifted. But what’s curiouser is that there was very little action over the past few months. The latest Financial Stability Report of the Reserve Bank of India (RBI) has highlighted certain systemic risks which have sprung from regulatory gaps in capital markets and discontinuities in the inter-regulatory coordination space. The report lists all the usual risks: a deteriorating domestic and global economy, tepid demand resulting in slowing credit growth, a rising burden of bad loans, heightened risk from high corporate leverage, among others. But it also underlines how different markets are linked, how economic agents shift investment preferences between markets but jurisdictional regulators come up short, showing up cracks in the inter-regulatory regime.
One example that stands out is the emergence of insurance companies and mutual funds as the highest fund providers in the system, stepping into the breach left by credit-averse banks. On the other side of the equation, non-banking finance companies and housing finance companies have become the biggest receivers of credit, surpassing the manufacturing and services sector. Ordinarily, this should have been welcomed as a sign of a maturing market, with a multitude of credit providers with heterogeneous risk-return horizons providing depth and liquidity to the country’s debt market. But, as credit defaults have showed, there was a rush to maximize yields with little concern for risk or asset-liability mismatches, leading to investors losing money. Mutual funds and insurers, or pension funds, have high fiduciary responsibilities, and the weaknesses exemplify the need for sectoral regulators to review their internal processes for risk assessment and mitigation. The second risk emerging is a sharp jump in the assets under management (AUM) of debt-income funds: by 70% over 2015 to 2020, to ₹11.8 trillion. But what is even more dangerous is the dominance of non-retail investors in these funds, making them susceptible to runs. Corporate and high net worth individuals had a 90% share of aggregate debt fund AUM at the end of December 2019, against only 48% in equity funds.
Two clear lessons emerge. One, that there is nothing wrong in mutual funds, insurance companies or pension funds investing in credit products to diversify portfolios, seek predictable cash flows and match liability tenures. But credit discipline must be equal across markets, or else it opens avenues for regulatory arbitrage. Banks have to follow well-defined prudential norms while providing credit. For a level playing field, the same should apply to all other credit dispensers. On another note, RBI should expand the Report’s ambit to include more players: for example, private equity has emerged as a large credit source and defaults here have systemic ripple effects. Second, sectoral regulators should heed risks arising from market inter-connectedness, requiring more robust inter-regulatory coordination. The functioning of the Financial Stability and Development Council, created for this purpose, is rather too opaque and seems to be failing in its task. Proforma reports of its meetings should be replaced with more detailed bulletins