Sebi and RBI take away the punch bowl

In the past few weeks, India’s top two 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 for allegedly violating norms repeatedly over several years. Then, the central bank debarred it from accepting fresh deposits and credit transactions after March 15, which could effectively mean curtains for the bank. On March 4, the RBI imposed an embargo on IIFL Finance’s gold loan business and the next day it banned loans against shares and the IPO (initial public offering) financing business of JM Financial Products, citing “persistent regulatory non-compliance and governance issues”. Finally, on

March 7, the Securities and Exchange Board of India (Sebi) prohibited JM Financial from taking on new mandates to serve as lead manager for the public issue of debt instruments for reportedly flouting regulatory norms.

Separately, alarmed by the money flooding smallcap 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 smallcap and midcap schemes. The stress test will cover the 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 will be required to state the number of days required to liquidate 25 per cent and 50 per cent of smallcap and midcap portfolios. I am not sure if “simple language” can communicate the implications of financial jargon like “annualised standard deviation, portfolio beta, etc.,” but Sebi’s efforts are timely and necessary. The action of the RBI and Sebi has naturally attracted criticism.

Paytm is the poster boy of fintechs 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 Financial 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 bona fide 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 the action is at odds with some people’s financial interests; if they don’t act, they are blamed for being lax when a 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 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 the RBI, under Y V Reddy, kept increasing risk weightings 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 the 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 the RBI, Indian mutual funds could have been prevented from foolish investment 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 the current actions of the RBI and Sebi are correctly timed. The Indian stock market has been on a tear over the last year. Froth in smallcap stocks is obvious. In the calendar year 2023, the NSE microcap index was up 66.1 per cent while the Nifty50 was up only 20 per cent. 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 smallcap funds, flipping IPOS on the listing day, apart from trading massively in options.

William Mcchesney Martin, a businessman who was chairman of the Federal Reserve between 1951 and 1970, had famously said that the task of the Fed was 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. Mr Prince 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 till people get hurt, and the regulators have to clean up their mess.