How regulations have failed our fixed-income securities market

The events unfolded just as the covid crisis started to become a serious threat, spooking investors. As the global economy began to feel the heat, there were momentary capital outflows from emerging markets, leading to significant capital market volatility. Amid falling interest rates, the understanding at the time was that global capital might find solace in safe-haven assets elsewhere.

The ensuing panic led to redemptions to the tune of $26.3 billion in March 2020 from debt- focused funds. These pressures left relatively risky debt funds vulnerable, as liquidity became an obstacle in meeting commitments. This was also because there was no interest in the secondary market for a significant quantum of corporate paper held by mutual funds. Amid drying FII money, while RBI had no specialized window dedicated to the industry, uncertain commercial banks excused themselves by pointing to their rising liquidity coverage ratio (LCR) obligations.

Needed at 100%, the LCR is a short-term liquidity stress test, measured as a ratio of high-quality liquid assets (HQLA) stock and 30-day net cash outflows. Ironically, while banks often use mutual funds as vehicles for gaining exposure to corporate debt, they are reluctant to hold such securities directly. The sudden increases in key benchmark yield spreads made matters worse.

RBI’s subsequent introduction of a $6.6-billion special liquidity facility for mutual funds, which was announced on 27 April 2020, was an admission of its earlier oversight. It marked a realization that the industry’s vulnerabilities cannot be ignored. Over the years, the fixed-income mutual fund industry has emerged as an important financier of India’s nearly $500 billion corporate debt securities market. Debt-focused mutual funds collectively manage $212 billion of assets (as of August 2021), or the equivalent of roughly 7% of India’s gross domestic product (GDP), compared to the 26% averaged by the EU and US mutual fund industries. Nevertheless, India’s mutual fund industry punches above its weight. It directly finances about 43% of the country’s corporate debt instruments. The global average among peers is just over 15%. The industry is possibly the only source of funding for a significant quantum of debt issued in the segment. These numbers become starker when one considers that for paper rated below AA (-), a secondary market essentially does not exist.

Oriented for decades by statutory holding requirements that are among the world’s highest, commercial banks in India have traditionally found safety only in government debt securities, despite their pivotal role in the country’s fixed- income market. Once bitten by the bad-loan bug, banks have also become risk averse and have since been building their portfolios with paper that enjoys the best ratings achievable. On average, the proportion of government securities held by Indian banks is nearly 85% of their investment portfolios and over 21% of their total assets. This is extraordinary, as research by Gennaioli et al has shown that the world average is just around 9% of assets and goes to around 11% in periods of crisis. This crowds out non-government paper in India.

Perhaps a better understanding of this situation can be gained through a more detailed assessment of the HQLA stock, which has a significant overlap with Indian statutory liquidity ratio (SLR) guidelines. Since both SLR and HQLA Level 1 stocks consist of the highest quality liquid assets, over 94% of such portfolios are made up of government securities. In fact, HQLA Level 1 stock not only includes government securities in excess of SLR requirements, but also equivalent SLR carve-outs such as for the marginal standing facility and the facility to avail liquidity for liquidity coverage ratio (FALLCR). Level 2 HQLA, on the other hand, aims for diversification through lower rating requirements and is capped at 40% of the total HQLA stock. This cap, however, is never reached in practice as instruments issued by non-bank lenders and mutual funds are ineligible.

Theoretically, the higher the Level 1 stock, the healthier the LCR, since the segment attracts a 0% risk weight under the Basel Committee on Banking Supervision guidelines. During the crises, as commercial banks raced to safeguard their balance sheets, HQLA Level 2 stock received a further blow, as certain banks increased the share of FALLCR multifold at the cost of their Level 2 obligations. Consequently, major commercial banks nonchalantly increased their LCR significantly from 110-120% before the crises to over 130%. The initial failure of RBI’s long term repo operations 2.0 is a case in point. Banks were sceptical of parking cash in corporate paper, fearing an impact on their LCR. The purpose of HQLA Level 2 norms is to enhance stock diversity. But an unfortunate lack of quota guidelines for corporate paper in the segment has reduced the depth of the secondary market even further.

A resolution of the problem, therefore, would necessitate a deepening of the country’s secondary bond market. RBI must set up a window or special purpose vehicle for the direct purchase of corporate debt during times of crises, as other central banks such as the US Fed, European Central Bank and Bank of Japan have done. Secondly, it must enable corporate paper acceptability among commercial banks, as this will aid their tradability. This can be done by way of a revision in HQLA stock calculation rules, requiring the inclusion of corporate debt at least at Level 2, with certain relaxations in credit-rating requirements. Importantly, HQLA regulations must not be open to interpretation, but rather mandated at both levels.

Recent events have shown the vulnerability of the fixed-income segment, which plays an important role in making our capital markets resilient. The darkest hour is the best time to prepare.

Karan Mehrishi is an economics commentator and author of ‘The India Collective: What India is Really All About’