RBI restricts banks investment in liquidity plans by mutual funds

The Reserve Bank of India, in its annual monetary policy statement on Tuesday, restricted banks’ investment in liquid plans floated by mutual funds at 10% of their net worth, thus curtailing an assured avenue of inflows for the mutual fund industry.

Banks’ exposure to liquid funds will be based on their net worth as on March 31. Banks with over 10% of net worth invested in liquid plans have been given six months to comply with the norm.
With banks’ cumulative net worth around Rs2.5 lakh crore, their exposure to liquid plans will now be capped around Rs25,000 crore, said fund managers. “Banks have around Rs1.5 lakh crore (invested) in the fund industry,” said the head of debt at a bank-sponsored fund house. As a large chunk of this money is invested in liquid plans, funds may see a sizeable outflow, he said.

Banks’ investments in liquid plans were giving rise to circular flow of funds, RBI noted.

“Debt-oriented MFs invest heavily in certificates of deposit of banks. Such circular flow of funds between banks and DoMFs (debt-oriented mutual funds) could lead to systemic risk in times of stress/liquidity crunch. Thus, banks could potentially face a large liquidity risk. It is, therefore, felt prudent to place certain limits on banks’ investments in DoMFs,” the RBI said.

It also raised concerns that liquid schemes rely heavily on institutional investors such as commercial banks. Such investors’ redemption requirements are normally large and may thus put fund houses at risk in times of tight liquidity.

RBI’s move is likely to bring down investments in liquid schemes by almost 50% in the next six months, industry officials said.
“With the cap on banks’ investments in mutual funds’ liquid plans, investments are likely to nearly halve in the next few months,” said Lakshmi Iyer, vice-president and head-fixed income and products, Kotak Mahindra Mutual Fund.

A Balasubramanian, chief executive officer, Birla Sun Life Mutual Fund, said nearly `60,000 crore is likely to move out from the industry in the next six months.

Net assets of liquid funds as of March-end stood at `73,666 crore, down 57% on month, according to data from Association of Mutual Funds in India.

Some fund managers applauded the move as it is expected to ease volatility in such schemes. Generally, banks withdraw investments in liquid funds to pay quarterly advance tax, for which fund houses have to maintain significant cash in their liquid fund portfolio.