Finance and Economics Education for the Life Insurance Sales and Marketing Persons
Knowledge is Power
Learn Concepts that Are Today’s Market Language
This is the third article of the Explained Series of Articles from me. In this series I will be explaining a few concepts in financial theory and how they are linked to selling life insurance. It is important to know these financial concepts to understand the financial markets and also to know how to canvas for life insurance products.
Recently a friend of mine asked how do the NPAs in banks affect the mutual fund investors. After a bit if study I found some interesting information in the Financial Stability Report of the RBI. This Report is published by RBI twice a year. The latest Report available is of June 2018. The next Report will be published in January 2019. From the June 2018 Financial Stability Report of RBI, we get very interesting information on the risk that the mutual fund investors carry. All too easily the mutual funds use the statement “mutual funds are subject to market risks”. But what does this statement mean in actual practice. In this article we explore one such risk in practical terms, from the data published by RBI.
NPAs in Banks
Banks over the last few years have piled up a very large amount of non-performing assets (NPAs). NPAs for banks are those borrowers who have defaulted in their loan repayments. Most of the NPAs are such that they are in no position to repay. The value of such loans is more than Rs.10 lakh crores. A body has been formed to sell off the defaulting company and repay the banks and other creditors. Banks are now in serious trouble as the companies that are buying the defaulting companies are only paying a fraction of the amount due. This is referred to as a hair cut. Hair cuts are leaving the banks with 20 to 30 % recovery of the loans they have given.
Liquidity Crunch in NBFCs and Housing Finance companies
Similarly, NBFCs have come under a very big liquidity crunch after the recent IL&FS default. They do not have money to lend. The near term outlook for NBFCs is bleak. If they do not act in financially prudent manner, many of them can even close down. The severity of the problem is such that a delegation even met the Prime Minister to seek a solution. The housing finance companies and the real estate sector depend heavily on the NBFCs for their borrowing needs. NBFCs are not lending due to their liquidity crunch. So along with NBFCs, the housing finance companies are also in big trouble. They are not getting the funds required for operating their business.
The link between bank’s hair cut and mutual fund investor
Now how does hair cut by banks affect the mutual fund investor? Mutual funds have invested heavily in banks. By taking hair cuts, banks will end up in a loss. Suppose a mutual fund invests in a bank through Certificate of Deposit. If the mutual fund is prepared to wait till maturity of the Certificate of Deposit, the fund will get back the promised amount. But usually with changing equations in the financial markets, the fund manager keeps shifting investments from one investment to another in an effort to earn more. When the bank’s prospects are down, any attempt to sell the Certificate of Deposit either back to the bank or to open market will lead to a drop in the value of the deposit. The fall in value is the hit that the mutual fund investor takes. The value of the Certificate of Deposit has dropped because of the hair cut and resulting in a loss to the bank. A hair cut by banks will lead to a loss of value in those investments leading to a lower return for the mutual fund investor. Mutual fund investors can potentially go bald with the bank’s hair cut.
Data from Reserve Bank of India
From the Financial Stability Report, June 2018, we learn that nearly 60 % of the mutual fund assets under management (AUM) has been invested in banks, NBFCs, and housing finance companies. 41 % has been invested in banks, 10 % in NBFCs, and 8 % in housing finance companies. Of the 41 % invested in banks 45 % was invested as short term lending to banks. None of the three sectors – banks, NBFCs, and housing finance companies – are currently doing well and are unlikely to be doing well in the near future. They are like investments that have turned sour.
What are risks that mutual fund investors are bearing as per the above data?
Firstly the high concentration of mutual fund investments in the troubled sectors means that mutual fund investor is exposed to the risk of failures in the banks, NBFCs and housing finance companies, where the mutual funds have invested. The investors face the risk of falling NAVs because the investments made are currently very high risk in nature.
Secondly, 45 % of investments is short term in nature. The risk of short term liquidity crisis of the banks, NBFCs and housing finance companies. That is banks or NBFCs or housing finance companies will have to repay the mutual funds in the short term. The short term is the period when these banks and companies do not have the liquidity. So mutual funds will find it difficult to recover money and their investors will lose even more value and resulting in further drop in NAVs.
Thirdly, banks, NBFCs, and housing finance companies have borrowed short term money, but their own investments through lending is for longer terms. Their returns are from assets which pay in the long run. There is therefore a risk of asset-liability mis-match at the banks, NBFCs and housing finance companies. The asset-liability mis-match may not be a very high risk if those organisations are doing good business and are running profitably. But the situation that they find themselves in currently, the asset-liability mis-match will lead to defaults in repayment to the mutual funds. The overall risk is therefore further increased and the mutual fund investor is carrying more risk.
Don’t forget to educate your customers
Let us wait for the January 2019 Report of RBI to get the latest data. In the meanwhile do not forget to educate your customers about the risks of investing in mutual funds.