5.5.3 Assured Return Schemes and Mutual Fund Solvency

A mutual fund is one of the institutions that, in theory, requires almost no risk capital (Merton
and Perold, 1993). However, in India many mutual funds, particularly in the public sector
operated schemes that guaranteed a minimum return. These were like bank deposits
sweetened with a call option on the stock market, but many mutual funds failed to recognise
the risks involved in these products. When the portfolios of these schemes did badly (partly
due to poor management and partly due to the lacklustre performance of the market itself),
the mutual funds had great difficulty in fulfilling their return guarantees. Under pressure from
SEBI, the public sector banks and insurance companies that had sponsored these mutual
funds provided financial support of nearly Rs 20 billion to the mutual funds to allow them to
honour the guarantees. Of these seven mutual funds, one needed a support of Rs 12 billion,
three needed about Rs 2 billion each, and three needed relatively small amounts