Putting all eggs in one basket

The dominance of banks in the mutual fund space raises questions about financial stability that require careful examination

Mutual funds’ story has proven to be a good one for India. At present, there are 43 mutual funds (MFs) offering around 1,280 schemes to millions of investors through 147.4 million folios, and managing around Rs 43.20 trillion assets. This represents impressive growth from assets worth just Rs 0.80 trillion 20 years ago in 2003 — a compound annual growth rate of 22 per cent. 

MFs have played a pivotal role in inculcating a culture of investing among the masses in India, and have emerged as an alternative to putting savings in bank fixed deposits. In 2003, MF assets under management (AUM) accounted for 6 per cent of bank deposits; it has risen to around 21 per cent in 2023. The entrepreneurs raising funds, through both equity and debt, have been major beneficiaries of MFs’ investments in their instruments. MFs have helped the capital markets in India to emerge as an alternative to bank financing. The total AUM of MFs at present has crossed over 31 per cent of outstanding bank loans. This shows the growing heft of MFs in the financial sector.

Several aspects relating to the MF industry are worth discussing. This article focuses on the ownership profile of this industry. 

The top MFs in India, in terms of AUM, are affiliated with banks in the country. This has been the case for the past two decades, with the dominance of bank-affiliated funds only increasing over time. On March 31, 2003, top five MFs accounted for 54.55 per cent of the total MF assets, and two out of these five were sponsored by the banks (excluding UTI MF). As of March 31, 2023, the share of top five MFs was 55.64 per cent, with four out of these five being bank-affiliated. 

According to regulatory provision, the sponsor of an MF needs to contribute at least 40 per cent of the net worth of the AMC, which, in turn, has to have a net worth of at least Rs 50 crore. The investment requirement is not linked to the AUM of the MF. There is no requirement of any risk capital provisioning on the books of MFs as they are pass-through vehicles; the risks/ rewards are directly borne by/go to the investors. Banks, on the other hand, have capital adequacy requirements, which are closely monitored by the Reserve Bank of India (RBI). Of course, the participation of banks in the MF space as sponsors, as well as distributors of MF products, is with the approval of RBI, and in accordance with the Securities and Exchange Board of India (Sebi) regulations. 

A major factor favouring bank-affiliated funds is their public outreach through their branches, which are spread throughout the country. Bank-affiliation offers economies of scope and distribution externalities. Despite efforts by Sebi to encourage direct access to buying funds, individual investments continue to be distributor driven. MFs are push products — bank-affiliated funds enjoy brand identification and customer loyalties.  

That brings us to two questions — does the MF industry lack competition, and is there anything wrong with banks dominating this industry? 

On the face of it, the answer to the first question appears to be negative. According to a recent Sebi consultation paper, eight MFs had market share of over 5 per cent each and the combined AUM of these eight MFs was about 75 per cent of the total MF AUM. Now, eight large players should be good enough to provide the required competition in the market. Even taking into account the fact that most of them are bank-affiliated, there is no reason to expect an oligopolistic behaviour, considering the fact that these banks compete aggressively amongst themselves in their banking activities. 

The answer to the second question may not be that straightforward. It is a fact that even globally, the bank-affiliated MFs have a significant share of the market — estimated to be around one-third. In India, this proportion is much higher at over 60 per cent. Undoubtedly, the banks have done yeoman’s work in deepening MF’s reach.

That said, note that MFs compete with banks’ core activities — borrowing and lending, which are the basic constituents of banking. Remember, banks were forced to increase their deposit rates during the last year not because of the increase in repo rates, but because they had to compete for deposits with the alternative investment opportunities available to customers, including MFs. 

On the lending side, bank loans compete with corporate bonds. Note that the share of bank-affiliated debt funds in the total debt funds’ AUM is pretty high at around 65 per cent.

Do banks and debt funds of their affiliate MF compete with each other for good lending opportunities? If yes, who is likely to prevail? Are banks able to influence the investment decisions of their affiliate MFs? Is the riskiness of an investment the deciding factor in choosing between the two options? Remember, a debt MF doesn’t hold any risk capital. In the case of a credit default, the MF could create a side pocket to segregate the bad assets and carry on with managing the remaining assets. Of course, in the event of repeated side pocket creation, the MF is likely to suffer reputational loss, and may lose customers going forward. Also, Sebi’s mandate regarding skin in the game for AMCs and their managers in their investments may deter MFs from taking undue risks. 

Banks posted fantastic financial results in 2022-23 due to a phenomenal increase in their net interest margin (NIM) income on account of the spread between borrowing costs and lending rates. The question to be asked is whether banks would actively encourage MFs, which may impact both their borrowing and lending activities, and in turn their NIMs?

One needs to dig deeper into the working relationship between a bank and its affiliate MF. Also, carefully examining the related-party transactions (RPTs) between banks and their sponsored MFs is crucial.

Another important issue is interconnectedness in the financial sector, which should be contained to maintain financial stability — a direct learning from the global financial crisis of 2008. Theoretically, a bank and its sponsored MF are two separate entities, and with MF’ books carrying little risks, there may not be much contagion risk.  However, in reality, in a crisis situation, things may play out differently. The banks may be forced to take actions, going beyond the minimum regulatory requirements, as may be needed, to protect their reputation and brand value. 

Is it a good idea for banks to dominate both the banking sector and the MF space? In fact, banks also dominate the insurance sector, further exacerbating the interconnectedness. Policymakers and regulators need to give a serious thought to this. 

The writers are, respectively, former chairman, Sebi, and professor at the National Institute Of Securities Market