In the past few weeks, India’s top-2 financial regulators have flexed their muscles to teach market participants some basic lessons in prudence and regulatory compliance. First, the Reserve Bank of India (RBI) imposed business restrictions on Paytm Payments Bank Ltd for repeated violation of norms over several years. Then, the central bank barred it from accepting fresh deposits and credit transactions after 15th March which could effectively mean curtains for the Bank.
On 4th March, RBI imposed an embargo on IIFL Finance’s gold loan business and, the next day, it banned loans against the shares and IPO (initial public offer) financing business of JM Financial Products, citing persistent regulatory non-compliance and governance issues. Finally, on 7th March, the Securities and Exchange Board of India (SEBI) prohibited JM Financial Ltd from taking on new mandates to serve as a lead manager for the public issue of debt instruments for flouting regulatory norms.
Separately, alarmed by the money flooding into small-cap funds, which could make the market frothier, SEBI has asked mutual funds to consider moderating flows and rebalancing portfolios and disclose the results of the stress test for small- and mid-cap schemes. The stress test will cover liquidity, volatility, valuation and portfolio turnover of such schemes, “along with guidance in simple language, assumptions and methodology, to enable the investor to understand the risk associated.” Asset management companies (AMCs) will be required to state the number of days required to liquidate 25% and 50% of small-cap and mid-cap portfolios.
I am not sure 'simple language' can communicate the implications of financial jargon like “annualised standard deviation, and portfolio beta” but SEBI’s efforts are timely and necessary. Both RBI’s and SEBI’s actions have naturally attracted criticism.
Paytm is the poster boy of fin-techs and a group of entrepreneurs and investors promptly rallied behind it, urging the RBI governor and finance minister, to 'review' and 'reconsider' the regulator’s decision. Action against IIFL and JM Financial brought out protests from these two companies.
JM even argued that “there have been no material deficiencies in our loan sanctioning process… not violated applicable regulations…no governance issues whatsoever and we conduct all our business and operational affairs in a bonafide manner.”
That was until SEBI’s order exposed its questionable practices such as “getting individual investors, who would otherwise not have participated in the issue, to make applications not just by providing funds to them but also by assuring them an exit at a profit on the listing day.”
Regulators are in an unenviable position. If they act ahead of potential disaster, far from getting kudos, they are criticised because it is at odds with some people’s financial interests; if they don’t act, they are blamed for being lax, when an actual disaster hits.
We know that the 2008 global financial crisis was caused by unbridled real estate speculation in the US and parts of Europe, as regulators slept. The US Federal Reserve chairman had openly said that there was no cause for alarm right up to the months leading to the crash.
However, in India, there was no frenzied speculation in real estate and, hence, no excesses. This was because RBI, under Dr Venugopal Reddy, kept increasing risk weightage on bank lending to real estate, to curb irrational lending. This caused a lot of irritation among bankers, with the managing director of one of the best private sector banks privately complaining about how silly RBI’s overcautious stance was. But, thanks to this prudent approach, consumer spending remained unaffected and the Indian economy kept growing. The Indian stock market did crash, but mainly due to the forced panic liquidation by foreign investors.
At that time, if SEBI had been as proactive as RBI, Indian mutual funds could have been prevented from foolish investments in fixed maturity plans which was the cause behind Lotus Mutual Fund going belly up and having to be rescued through a merger.
There are enough reasons why RBI’s and SEBI's current actions are correctly timed. The Indian stock market has been on a tear over the past year. Froth in small-cap stocks is obvious. In the calendar year 2023, the NSE microcap index was up 66.1% while the NIFTY was up only 20%. These returns are far above the long-term average and unsustainable. For long-term average returns to be lower, arithmetically, returns in future have to be meagre. But who is willing to accept this? Instead, egged on by market intermediaries, investors are ploughing money into small-cap funds, flipping IPOs on listing day, apart from trading massively in options.
William McChesney Martin, a businessman who was the chairman of the Federal Reserve (Fed) of the US between 1951 and 1970, had famously said that the task of the Fed is to “take away the punch bowl just as the party gets going.”
The party has been in full swing in India, as is clear from the widespread non-compliance and funny schemes of various market participants. In such extreme situations, the objectives of regulators must be necessarily at odds with those of market players.
What best illustrates this is the comment of Chuck Prince, former Citibank chief – contrasting that of Martin. Price had, infamously, said in July 2007, six months before the market crash started: “As long as the music is playing, you've got to get up and dance.”
This is an honest admission of how the financial game is played, but then finance is too serious a business to be left to party swingers, dancing and drinking until people get hurt and the regulators have to clean up their mess.
(This article first appeared in Business Standard newspaper)
Any form of "central planning" will end up making things worse, not better. Anyone well versed in financial history (and how markets work) will know this. If you want to mess with complex adaptive systems, good luck, because the joke is on you. Just because safety rules are in place doesn't mean there's safety on the roads. People still die. You will get to the point where speed limit has to be 5km/hr and destroy everything else...for what? To protect consumer stupidity?
It's no one's fault. If at all, it means the markets are functioning beautifully. Just make it easier to short sell. This way the market functions efficiently and serves its intended purpose -- to punish people who buy expensive assets. End of story.
SEBI is entirely responsible for this froth in small caps. They allowed all sorts of valuations at the time of IPOs and when the market was heating up, they simply watched and did nothing and now SEBI has helped the big manipulators and ditched the retail investors. The retail investors who have put their hard earned money in the small cap industries, on the basis of the valuations approved by SEBI has beenb cheated.
Both RBI & SEBI need to be complimented for their pre-emptive and pro-active measures. Any investment (including Gold) is risk prone and it\'s the risk taking capacity of an individual small investor as also his expectations of risk-return ratio that will guide him on his own investment strategy. Unfortunately, not many are financially literate in India. The SEBI approved financial advisors and RBI\'s mandated Financial Literacy programmes can help educate the masses and enable them to better investments with due understanding of the risks involved in such investments.
Exactly. Regulation introduces all sorts of 2nd and 3rd order risks effects and cascades.
Problem is most intellectuals and policy makers have no clue and discounts this. Nitpicking problems is their hobby. Regulators don't have to do anything other than catch culprits. Let the markets clean up the system on its own even if it means a bloodbath is coming.
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It's no one's fault. If at all, it means the markets are functioning beautifully. Just make it easier to short sell. This way the market functions efficiently and serves its intended purpose -- to punish people who buy expensive assets. End of story.
Problem is most intellectuals and policy makers have no clue and discounts this. Nitpicking problems is their hobby. Regulators don't have to do anything other than catch culprits. Let the markets clean up the system on its own even if it means a bloodbath is coming.