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The proof of the bail-out…

Subir Gokarn

The proof of the pudding might be in the eating, but the proof of the bailout is simply that it needs to be done only once.

By themselves, bailouts of precarious financial institutions are widespread. Even in the most market-oriented economies, they are justified on the grounds that the blame game failure of a large institution or a network of closely linked ones will have an adverse impact on the financial system as a whole.

The episodes involving the savings and loan institutions and the Continental Illinois Bank in the USA are clear examples of this motivation.

The fragility of these institutions, in hindsight, is usually an indication of some fundamental weaknesses in the regulatory framework, particularly with respect to prudential regulation.

It reflects the fact that managers could invest in activities far riskier than prevailing prudential standards would warrant, without immediate fear of regulatory sanction.

The new bailout is, therefore, typically accompanied by a significant tightening of standards as well as stricter monitoring of compliance. Success is measured by the fact that future fragility of the system cannot be attributed to the same set of factors.

If one is to apply this yardstick to the Unit Trust of India, the earlier bailouts have to be judged as failures. In 1998, the government forked out over Rs 3,000 crore (Rs 30 billion) , with some specific conditionalities attached.

The critical one, as per the recommendations of the Deepak Parekh Committee, was to make a speedy transition from assured returns to net asset value of all schemes whose portfolios contained any risky assets.

For whatever reason, this did not happen quickly enough to prevent the fiasco of a year ago, when the institution decided to suspend repurchases of its Unit Schem-1964 units.

Amidst the turmoil, a transition strategy was drawn up. Small investors in US-64 would be given an option to redeem at least some portion of their holdings at prices, which were somewhat more realistic, although still far above the prevailing NAV.

This approach at least bought some time for the institution, giving it the opportunity to benefit from a possible appreciation of stock prices.

This, of course, didn't happen and meanwhile, the pressure on UTI increased because of the maturing of other schemes. In the absence of any financial support from the government, the only option was to sell off large chunks of assets.

In an already depressed market, this could have proved to be the last straw. The only way in which UTI could obtain any kind of premiums on its holdings was to allow the people who bought them to gain control over the companies concerned. Ultimately, what choice did the government really have?

But, this is all water under the bridge. To get back to the yardstick, having coughed up the Rs 14,000 crore (Rs 14 billion) plus, is the restructuring plan good enough to ensure that this kind of thing will never happen again?

The key element in the plan is the bifurcation of the institution. One component, UTI-I will handle the assured return schemes and the other, UTI-II, the NAV-based schemes. The former will remain under public control, while the latter will be privatised eventually.

In the meantime, US-64 investors' option to re-sell to UTI at guaranteed prices will be extended beyond the earlier deadline of January 2003. Also, certain tax incentives to encourage investment in the schemes, the details of which have not been specified, are in the offing.

The logic of the restructuring plan stands or falls on a very simple portfolio principle. You cannot indefinitely give guaranteed returns by investing in risky assets. It has been repeatedly argued that this mismatch is at the core of UTI's problems. Does the proposed restructuring address it?

Yes. Part of it will, of course, be used in redemption, but the rest will, in effect, act as new subscriptions to UTI-II, which can then buy out the risky (mainly equity) assets of UTI-I. This money is, in turn, used by UTI-I to invest in fixed income securities, consistent with its commitments of assured returns.

Sounds rather nice and neat and, with a little help from the markets, it might well work too. As long as UTI-II generates enough surpluses from its funds to service its government "subscriptions", the scheme pays for itself.

Even if it doesn't, the exposure has now been shifted from the small investor to the government, which can always accommodate it into its budget over a period of time.

But, let's look at the likely catches. Why should small investors in the schemes of UTI-I bear the overheads incurred by the institution, when the same kind of return profile can be found in schemes like the Public Provident Fund, which incur far lower overheads, because they are serviced out of bank branches and post offices?

And, why, given the recent growth of debt mutual funds, should the government continue to underwrite a public institution offering a similar investment option? Public ownership creates a distortion by giving the investor grounds to believe that there will be a bailout in times of trouble.

In short, the "business model" proposed for UTI-I appears to be flawed because in the current financial scenario, there are a number of alternative mechanisms that will deliver the same service at lower cost.

The objective of the restructuring should be to ensure that the lowest-cost alternative is given priority. It's not clear that this is happening in this case.

This problem will be compounded by the proposed tax sops for investors in the institution. Fiscal reforms are moving, quite legitimately, in the direction of eliminating tax concessions for savings in instruments that finance current government expenditure. Politics may create its own short-term pushes and pulls, but the long-term tendency is unmistakable.

Given this, tax incentives to invest in an institution that appears to have some inherent inefficiencies can only be seen as a step backward.

The concept of UTI-II, particularly the government's stated intention to privatise it at an appropriate time, is more tenable.

A practical way of doing this is to carve up the institution's debt obligation to the government into "units" and offer them for sale to individuals, with perhaps a floor price.

Since the trading price of these units will be directly linked to the NAVs of the schemes to which they are attributed, the government can also hope to benefit financially in a rising market. More important, this approach has relatively low potential for causing turbulence in the markets.

Overall, to return to our yardstick, this latest bail out for UTI is large enough and comprehensive enough to have a reasonable probability of being the last.

But, it needs to go further in dealing with the potential inefficiencies inherent in UTI-I. As difficult as it is to do, a spade has to be called a spade and an obsolete institution obsolete.

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