Mutual funds that invest in highly liquid instruments (liquid funds) may face redemptions in excess of Rs 60,000 crore over the next six months, amounting to a third of their assets.

In a move to prevent the circular flow of money between mutual funds and banks, the RBI, in its recent monetary policy, asked banks not to hold more than 10 per cent of their net worth in liquid mutual funds.

Indian scheduled banks had a combined net worth of nearly Rs 5 lakh crore, based on a rough calculation extrapolating the data for listed banks. RBI data show that these banks held Rs 1.18 lakh crore in liquid funds as of April-end.

Given that the RBI caps the investment in liquid funds at Rs 50,000 crore (10 per cent of net worth), this suggests excess investment of Rs 68,000 crore in liquid funds.

Redemptions of this size may significantly dent liquid funds as a category. According to the latest data from the mutual funds' body, liquid funds manage total assets of Rs 2.2 lakh crore. The banks' excess investments amount to almost a third of this.

Blow to the category

Sources in the fund industry confirmed that this will deal a severe blow to the debt fund category, as banks were a source of “easy money” to liquid funds. Eighty per cent of all banks are said to have used liquid funds to park surplus money. With banks unlikely to be a major source of assets, debt fund houses may also have to scout for other clients.

However, debt fund managers clarify that liquid funds will have no problem meeting the redemption requests, as the category has traditionally seen huge inflows and outflows. Over the last few months, these funds routinely saw both inflows and redemptions in excess of Rs 5,00,000 crore every month.

The RBI has cited the “circular flow of funds between banks and debt mutual funds” and the “systemic risk” this creates while making this decision to cap liquid fund investments by banks. While banks park money in liquid funds, they in turn redirect this money into certificates of deposit issued by banks. This, RBI fears, could lead to a liquidity risk for banks during a crunch situation.

As for banks, they may certainly lose out on an opportunity to earn a neat “arbitrage” return on liquid funds. Liquid schemes have generated returns of even up to 8.7 per cent a year in the past. This allowed banks to earn arbitrage profits by borrowing in repo window or the money market at lower rates and deploying this with liquid fund managers. This may not happen going forward.

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