Policies should focus on improving the ease of entering business, not just the ease of doing business
It is nearly time for another Budget and new policy announcements by the government. For speeding up economic growth, we may think in terms of a few grand policies or a hundred small steps. Here I take the latter approach and consider just one policy. There is a need to remove barriers to entry in businesses. I will confine myself here to the entry barriers for new asset management companies (AMCs).
Mutual funds are run by AMCs. At present, in India such AMCs are required to have a minimum capital of Rs 50 crore (there are other restrictions as well). It is interesting that the capital requirement in the US is only $100,000, which is, relatively speaking, peanuts. The huge capital requirement acts as a barrier to entry in India. Now some may not like to compare India with the US. So, let us consider the first principles and do so for financial intermediation in general. Financial intermediaries include, inter alia, AMCs and banks.
A bank takes risks and can face non-performing assets (NPAs) but it promises fixed returns to its depositors. If there is a loss in any year, a bank can, by and large, absorb the loss by depleting its capital temporarily, and the depositors can be paid as promised. So, there is indeed a need for adequate capital (or deposit insurance in one way or another).
We can now come to the other set of intermediaries viz, AMCs. All the gains and the losses go to the investors; the AMCs charge a fee and offer the customers net asset value (NAV). So, there is hardly any financial risk for the AMCs. It follows that the AMCs do not need to have any capital in this context. Of course, they need some capital for operations but that is different, small, and specific to each AMC.
It is interesting that we keep coming across the following caution in advertisements: “Mutual funds are subject to market risks.” But we hardly see the following: “Banks are subject to market risks.” This says it all. Banks, unlike mutual funds, promise fixed returns. So, a substantial capital requirement is needed for banks but not for AMCs. However, a capital requirement has been imposed on AMCs as well!
Occasionally, though not warranted, if the promoters or the senior managers of an AMC would like to take responsibility for some potential serious losses to investors, they can always do so by buying units of the mutual fund at a price that is higher than the market price. So, even here, there is no need for a general and mandatory capital requirement.
Consider a broader perspective. The licence Raj was abolished in India in 1991 in the manufacturing sector; it was not abolished more generally. One example of, what is effectively, licence Raj, and not prudential regulation, is the huge capital requirement for AMCs in India.
We do have good competition between a large number of AMCs at present. However, it is competition between established names like ICICI, SBI and Nippon. “Out of the blue” names in AMCs are very few, if any at all. This is not just inegalitarian, it is inefficient. Competition is a procedure for discovery in the market. If we have restricted entry, then truly efficient names are unlikely to be discovered in the first place.
It is true that we have the Competition Commission of India. But this cannot keep a check on the absence of competition that is due to legal and regulatory barriers to entry. It is also true that there is a minimal barrier to entry in running a portfolio management scheme (PMS); potential entrants could go there instead of setting up AMCs. However, that is a different and smaller market.
It is true that the legal, regulatory and institutional framework (LRIF) under which intermediaries like AMCs operate is inadequate in India. This, some may argue, justifies the barrier to entry in this business. I differ. Let us understand this. The government is spending massive amounts on physical infrastructure in the form of “world class” highways. We need a balance here. We need to also spend on improving the LRIF, which is a different and equally important part of the infrastructure, broadly defined. Returns at the margin are much higher there. Alongside the improvements in the LRIF, barriers to entry in businesses can be reduced.
We know of young, dynamic and “middle class” entrepreneurs in many start-ups, but do we know of anyone from such a group who has set up an AMC? Hardly. Why? An important reason is the barrier to entry. We need to improve the ease of entering business, not just the ease of doing business.
The writer is visiting professor at Ashoka University. firstname.lastname@example.org