Subir Gokarn: Mutual funds and market development in India
Address by Dr Subir Gokarn, Deputy Governor of the Reserve Bank of India, at the CII
(Confederation of Indian Industry) 7th Edition of Mutual Fund Summit 2011, Mumbai,
22 June 2011.
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Inputs from Sudarsana Sahoo, Bhupal Singh and Deepa S. Raj are gratefully acknowledged.
I. Introduction
Financial sector development can be viewed as a process that enhances four critical
attributes of the financial system: efficiency, stability, transparency and inclusion. The
emergence of intermediation mechanisms and products that help improve on one or more of
these without causing others to weaken are, therefore, a meaningful indicator of financial
development.
From this perspective, Mutual Funds play an important role in the development of the
financial system. First, they pool the resources of small investors together, increasing their
participation in financial markets, which helps both inclusion and the efficient functioning of
markets themselves, as a result of larger volumes. Second, Mutual Funds, being institutional
investors, can invest in market analysis generally not available or accessible to individual
investors, thereby providing services based on informed decisions to small investors.
Decisions made on the basis of deeper understanding of risks and returns contribute to
financial stability, besides helping to mitigate market risk for this group of investors. Third,
transparency in investment strategies and outcomes, though typically mandated by
regulators, is relatively easy to deliver on, so that investors can find out exactly where they
stand with regard to their investments at any point of time.
As far as regulation is concerned, Mutual Funds cut across domains. The Reserve Bank of
India regulates three categories of financial markets; money markets, government securities
markets and foreign exchange markets. Mutual Funds have a presence in the first two and
the Reserve Bank is therefore interested in the role that they play in developing them. In
what follows, I shall provide a brief description of the role of Mutual Funds in these two
critical markets and discuss some of the regulatory issues that arise. I shall then make some
more general comments about the role of Mutual Funds in financial inclusion.
II. Mutual funds and market development
Mutual Funds have contributed significantly in broadening and deepening of different
segments of the Money Market and, to some extent, the Government Securities market.
Money Market Mutual Funds (MMMFs) were introduced in India in April 1991 to provide an
additional short term investment avenue to investors and to bring money market instruments
within the reach of individuals.
The guidelines for MMMFs were announced by the Reserve Bank in April 1992. The Reserve
Bank had made several modifications in the scheme to make it more flexible and attractive to
banks and financial institutions. These guidelines were subsequently incorporated into the
revised SEBI regulations. In October 1997, MMMFs were permitted to invest in rated
corporate bonds and debentures with a residual maturity of up to one year, within the ceiling
existing for Commercial Paper (CPs). The minimum lock-in period was also reduced
gradually to 15 days, making the scheme more attractive to investors.
MMMFs have witnessed phenomenal growth over the period. As on May 31, 2011, the total
assets under management of the MMMFs was placed at Rs.1,83,622 crore1, 25 per cent of
the aggregate assets under management of the Mutual Funds.
In order to promote retail holding in government securities and broaden the investor base,
Mutual Funds which invest exclusively in government securities, Gilt Funds, were introduced.
The first Gilt Fund in India was set up in December 1998. However, Gilt Funds have
registered moderate growth. As on May 31, 2011, the total assets under management of the
Gilt Funds was placed at Rs.3,336 crore2, 0.5 per cent of the aggregate assets under
management of the Mutual Funds.
Mutual Funds occupy a large share of the primary market of Certificates of Deposit (CDs) and
CPs. As on June 10, 20113, the total holdings of Mutual Funds in CDs and CPs remained at
Rs.2,95,164 crore (66 per cent of the aggregate outstanding) and Rs.82,951 crore (65 per cent
of the aggregate outstanding) respectively. Mutual Funds have also provided substantial
liquidity to the secondary market segments of CPs and CDs. Their increased activity in the
secondary market corresponds to their growing portfolio of money market investments.
During the last six months, MFs' share in the daily turnover the secondary market of CDs and
CPs stood at around 41 per cent and 46 per cent respectively.
The overnight segment of the money market has also benefitted from the participation of
Mutual Funds. Their reliance on the collateralized segment of the overnight markets, viz.
market repo and Collateralized Borrowing and Lending Operations (CBLO), for placement of
their daily surplus liquidity enhanced the depth of the markets.
By contrast, in the Government Securities market, the participation of Mutual Funds has not
been very encouraging. Of the outstanding Government of India dated securities4, the Mutual
Funds held 0.9 per cent as at end December 2010, which dropped to 0.2 per cent as at end
March 2011. The average holding of government securities by the Mutual Funds during the
last two years remained at 0.6 per cent as against 38.7 per cent by the banks, 22.4 per cent
by insurance companies, 8.9 per cent by PDs, 6.7 per cent by PFs, 3.1 per cent by corporate
entities. During the current calendar year till end of May, the average share of Mutual Funds
in the secondary G-Sec market remained at 5.8 per cent of the total traded volume. One
possible reason for the lower level of participation of Mutual Funds in the G-Sec market is
lack of investor interest in the gilt-oriented Mutual Funds due to significant interest rate risks.
III. Future role and regulatory issues
There is a need for Mutual Funds, especially gilt funds, to complement the role of PDs in
promoting retail holding in government securities. Mutual Funds are supposed to tap retail
investors, who in turn, to the extent that they have long horizons, provide stability to the
market. They also benefit small investors by providing them access to risk-free gilt edged
securities.
The Mutual funds are allowed to participate in the Interest Rate Swap (IRS) market for the
purpose of hedging their own balance sheet risks. However, their participation has remained
quite muted. The IRS market, although very liquid, suffers from a low customer base of
around 1 per cent. The Mutual Funds may increase the use of IRS for hedging their interest
rate risk which would help in broadening and deepening of the IRS market.
Mutual Funds are also allowed by SEBI to trade on Interest Rate Futures (IRF). IRF
contracts on 10-year notional coupon bonds were launched on NSE in August 2009. The
product witnessed significant activity during the initial period, but liquidity tapered off
subsequently. RBI has already issued guidelines for futures contracts on 91-day T-Bills,
which are expected to be introduced shortly. RBI is also considering introduction of IRF
contracts on 2-year and 5-year G-Secs. If the reason for Mutual Funds not actively
participating in the G-Sec market is the underlying interest rate risk, then they obviously
should make use of the IRF to hedge their interest rate risk. Their active participation will give
impetus to the development of the IRF market.
The launch of Credit Default Swap (CDS) is impending. The guidelines on introduction of
plain vanilla OTC single-name CDS for corporate bonds in India would be effective from
October 24, 2011. The Mutual Funds would be eligible to buy credit protection (buy CDS
contracts) to hedge their underlying credit risk on corporate bonds. They would also be
permitted as market-makers subject to their having strong financials and risk management
capabilities as prescribed by SEBI and as and when permitted by the SEBI. It is expected
that Mutual Funds' participation will provide momentum to the CDS market.
A significant feature of MMMFs or liquid Mutual Funds in India is that they have been mainly
catering to the short-term investment needs of institutional investors such as corporate and
banks whose redemption requirements are large and simultaneous. As on March 31, 20115,
the investor profile of liquid funds was dominated by corporate (76.5 per cent) followed by
Banks/FIs (17.1 per cent), HNIs (5.3 per cent). As a consequence, when the banking sector
faces liquidity shortfall and withdraws its investment from liquid Mutual Funds, they
collectively come under stress. This may lead to a sharp fall in banks' fresh investment in
liquid funds which, in turn, could intensify the pressure on those entities that receive
investments from the liquid funds.
It may be recalled that during October-November 2008, RBI had to provide a special
dispensation in the form of Term Repo facility of Rs.60,000 crores, under which banks could
avail central bank funds to address the liquidity stress faced by Mutual Funds, NBFCs,
HFCs. Banks were given an SLR exemption up to 1.5 per cent of NDTL to address this
problem.
A related issue is the circularity of funds between the banking system and Mutual Funds.
Banks invest in Mutual Funds and the Mutual Funds put large volume of funds back to the
banking system through investments in CDs, lending in CBLO and Market Repos. Such
circular flow of funds between banks and Mutual Funds has the potential for creating
systemic instability in times of stress/liquidity crunch. Thus, banks could potentially face a
large liquidity risk. In this connection, RBI had announced in the monetary policy on
May 3, 2011 that the bank's investment in debt oriented Mutual Funds to be capped at
10 per cent of net-worth as on March 31 of the previous year and banks would be given a
period of six months to achieve this limit.
From a prudential perspective, there is the possibility of banks' investments in the Mutual
Funds getting channelized to sensitive sectors such as real estate and stocks. This may lead
to banks' exposure to such sensitive sectors going beyond the prescribed prudential limits.
IV. Mutual funds and inclusion
The role of Mutual Funds in promoting savings continues to be insignificant in India. Despite
a long history, assets of Mutual Funds in India constitute less than 10 per cent of GDP. A
cross-country comparison suggests that Mutual Funds are very popular all over the world.
However, assets under them in India are relatively low as compared with other emerging
market economies.
One of the major reasons for relatively low activity of Mutual Funds in India is that
penetration, especially in the rural areas remains small. This is an important issue from the
perspective of financial inclusion of low-income households in the formal financial system. It
is generally perceived that Mutual Funds are popular mainly with the middle and high-income
groups and have not been found to be an attractive investment avenue for the low-income
groups. Thus, if the sector has to grow fast, it needs to devise appropriate schemes to attract
the saving of low-income groups, especially in rural areas. This is the only way to ensure
participation of all categories of investors in the financial markets, which is crucial for
sustained development, both of the financial sector and the economy as a whole.
V. Concluding remarks
Mutual Funds clearly have a significant role to play in financial development. Their modus
operandi of aggregating pools of saving from a large number of retail investors and deploying
these resources in a variety of financial markets, based on different risk-return preferences
simultaneously enhances efficiency, stability and inclusion. It is also relatively easy for them
to be transparent about both their strategies and outcomes.
This, of course, is a statement of ideal conditions. In the real world, there are clearly barriers
to achieving these objectives. Some of these have to do with penetration, others with the
preferences of investors, particularly with respect to duration, some more with legitimate
regulatory concerns about systemic risk and yet others with gaps or imbalances in the
broader regulatory framework. However, if there is broad agreement that appropriately
regulated mutual fund activity can play a large part in financial development in all its
dimensions, these barriers can surely be addressed in a collaborative way between the three
stakeholders - the investors, the fund managers and the regulators.