Renuka Sane, Ajay Shah, Bhargavi Zaveri
Why might the NAV be overstated?
The International Financial Reporting Standards (IFRS) notion of fair market value came about first in finance, on a global scale, and much later got enshrined into the IFRS. For example, in the United States, 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 recognises 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 easily 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 a certain date. 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, the 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 the 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 the 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 the ILFS bonds by 100 percent, while others have marked down by 25 percent, 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 sceptical about using rating agencies to override the 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 in this.
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. For example, 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 the NAV. It is the job of regulators to fight that, 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 June 30, 2000, it will be classified as NPA from October 1, 2000.
- The mutual fund must provision for the principal plus interest accrued up to the date on which the asset is classified as a NPA. SEBI prescribes a schedule for provisioning that mandates the mutual fund to provision up to 100 percent 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, such as the 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 the IL&FS 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 fund 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”. There is no role for banking-inspired ideas in mutual fund regulation.
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. Resultantly, 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 the IL&FS 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 the 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 or prevent them from coming into place. 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.
Disclaimer: Reproduced with permission from www.blog.theleapjournal.org. This is the second in the two-part series. For the first, click here.(Renuka Sane and Ajay Shah are researchers at NIPFP. Bhargavi Zaveri is a researcher at the Finance Research Group, IGIDR. Views expressed are personal.)