THE GIST of Editorial for UPSC Exams : 14 JUNE 2019 (NBFC crisis: Looking beyond MFs (The Hindu))

NBFC crisis: Looking beyond MFs (The Hindu)

Mains Paper 3: Economy
Prelims level: NBFCs
Mains level: Impact of NBFC crisis

Context

• Since ILandFS defaulted on its obligations and sparked off a liquidity crisis for NBFCs, the mutual fund industry has been hauled over the coals by commentators for its exposure to the troubled firms.
• The crisis has exposed several shortcomings in debt funds’ investing practices from chasing high yields and taking on concentration risks to over-investing in risky bonds where liquidity is wont to dry up at the first sign of trouble.
• With SEBI tightening valuation rules, debt funds have had to take immediate write-downs.

The impact of the NBFC crisis

• Over the impact of the NBFC crisis on mutual funds, investors and regulators must not lose sight of its implications for even larger bond market participants who are far less transparent.
• Of the ₹91,000 crore borrowed by the IL&FS group, the mutual fund industry accounts for less than ₹3,000 crore. Of the ₹1.1- lakh crore obligations of the DHFL group, about ₹5,200 crore is due to mutual funds. The rest is owned by banks, provident funds, pension funds, insurance companies and direct retail investors.
• While over 90 per cent of debt fund investments originate from institutions and high net-worth investors, uninformed retail investors account for the overwhelming proportion of the money parked with these vehicles. Here are some lessons for them from the recent turmoil.

EPFO, private provident funds

• The EPFO (Employees Provident Fund Organisation), the default retirement vehicle for over six crore workers, hires third-party portfolio managers to manage its ₹10-lakh crore corpus in line with the investment guidelines laid down by the Government and its Board of Trustees.
• Presently, it is required to invest 45-50 per cent in government securities, 20-45 per cent in other debt, 5-15 per cent in equities and the rest in money markets.
• When the EPFO mooted an interest payout of 8.65 per cent to its subscribers for FY19, the Finance Ministry questioned if it had enough surplus to fund this after accounting for its IL and FS exposures.
• That’s a pertinent question because the EPFO’s estimated surplus after the payout stood at only ₹152 crore, while its holdings in the troubled IL and FS bonds were valued at ₹574 crore.The numbers are relevant because the EPFO does not value its investments on a mark-to-market valuation and simply buys and holds bonds until maturity.
• Every year, it deducts its expenses from the interest and administrative charges it earns, to arrive at a ‘surplus’ which decides the return to its subscribers.
• The actuals, in some years, even differ from the estimated surplus because the EPFO’s annual accounts are finalised after a significant delay. The latest available accounts today are for FY17.
• This lack of a market-based valuation for its portfolio effectively means that defaults or downgrades in the EPFO’s bond holdings may remain hidden from view until their maturity.
• This makes the EPF quite an unsuitable vehicle to invest in any non-sovereign bonds that carry credit risks.

Insurers and pension funds

• When the ILandFS default first hit the bond markets, both the insurance and pension fund regulators seemed unsure about how their constituents should deal with the crisis.
• Some of India’s largest insurers such LIC, GIC, Postal Life Insurance Fund and Rural Postal Life Insurance Fund apart from the NPS hold ILandFS, while insurers and pension funds put together are estimated to hold ₹30,000 crore worth of DHFL bonds.
• In its initial reaction to the ILandFS default, the insurance regulator asked insurers to exit from the lower-rated bonds, while the PFRDA called for a dialogue with the borrowers.
• Both regulators seemed unaware of the ground reality that once a corporate bond is non-investment grade in India, its near impossible to find counter-parties for is sale.
• Both regulators have subsequently asked players to provision against these bonds.
• To be fair, default situations are quite unprecedented for both IRDAI and PFRDA, because their investment guidelines expressly bar their constituents from venturing into lower-rated corporate bonds.
• But if there’s one clear take-away from the recent strong of default, it is that the AAA or AA stamp from Indian rating agencies cannot be taken at face value any more.
• These agencies are prone to changing their minds drastically after episodes of delay or default unfold.

Public deposits and NCDs

• Public deposit schemes and NCDs floated by NBFCs and HFCs are quite a hit with retail regular-income seekers.
• To protect depositor interests, the RBI insists on an investment grade credit rating and caps the quantum of deposits at 1.5 times the NBFC’s net owned funds. NHB allows firms rated A or above to accept deposits at five times their net owned funds, with a ₹10 crore cap for un-rated firms.
• Given the fallibility of credit ratings though, it can now be questioned if these safeguards are enough to protect depositors in NBFCs/HFCs.
• If they delay or default on deposit dues, retail depositors figure pretty low in the pecking order as unsecured creditors.
• The RBI and NHB may need to usher in tighter and more uniform regulations for public-deposit taking entities.
• A liquidity mechanism akin to the statutory liquidity ratio for banks, and an escrow mechanism for liquidity needs can be examined too.
• In retail NCD offers, a mandatory quota for institutional investors as in IPOs and an insistence on security can perhaps safeguard investors.

Conclusion

• Delays and defaults are very much a part of the growth pangs that any bond market would experience as it evolves to meet the needs of a fast-growing economy.
• It is best that institutional players in the debt market and their regulators have a plan of action chalked out for such events instead of expecting a zero accident rate on their debt investments.

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Prelims Questions:

Q.1) Logistics Performance Index is released by
(a) The World Bank
(b) World Economic Forum
(c) United Nations Conference on Trade and Development
(d) World Trade Organisation

Answer: A
Mains Questions:
Q.1) A lot of attention has been given on the impact of the crisis on mutual fund investors, but bigger problems lie elsewhere. Critically examine the statement.