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All you wanted to know about Special Liquidity Facility for MFs

Vivek Ananth | Updated on May 05, 2020 Published on May 05, 2020

As Franklin Templeton Mutual Fund announced it was winding up six debt funds, there was fear in the market that other mutual fund houses might face similar challenges and liquidity shortages too. This fear stemmed from worried investors rushing to withdraw their savings parked in other debt funds, that might prompt them to sell bonds into an illiquid market. This was almost like a run on a bank, but more worrying because it could cause a larger credit crisis, even if only based on sentiment.

Market participants hoped the Reserve Bank of India would step in to stem the tide, taking a leaf out its own playbook from the 2008 financial crisis to soothe investor angst. The Special Liquidity Facility that the RBI has announced is in response to this.

What is it?

The SLF-MF is a two-week window in which the RBI will lend money to banks at the repo rate for 90 days. The funds that banks borrow under this window can be used only for meeting the liquidity needs of mutual funds. This could be either through outright purchase of certain debt instruments held by them, or lending to them using their bonds as collateral. The debt instruments so acquired can only be investment-grade corporate bonds, commercial papers, debentures and certificate of deposit.

The total amount that the RBI promised to lend through the SLF-MF is ₹50,000 crore, but this is subject to change in the future. The RBI has allowed banks to categorise the money borrowed using this facility as part of their held-to-maturity portfolio. Loans by banks to mutual funds under this facility would also not be considered as part of their capital market exposure and adjusted non-bank food credit. The latter is used to calculate banks’ achievement of priority lending targets.

Why is it important?

When Franklin Templeton wound up its six schemes, there was a fear that this could spook investors and turn into a financial contagion. Those six funds had already borrowed over their stipulated limit to meet their redemption needs, and were unable to sell debt securities below AAA to raise funds to meet redemptions.

Through this liquidity facility, the RBI has sent a signal to bond markets that it is willing to act as buyer of last resort for corporate bonds, although indirectly. The RBI has shown its intent to backstop any liquidity risk that mutual funds might face. However, it has allowed this facility only for investment-grade bonds and not other bonds held by funds. It has also preferred to do it through banks rather than directly step in.

The move did help reduce redemption pressures on credit funds in the past week. Banks, however, have not shown a lot of enthusiasm to use this special window.

Why should I care?

As the bank deposit and small savings scheme returns have been falling lately, many individual investors have parked their savings in debt funds. There are all kinds of debt funds, and the ones with higher risk earn a higher return. Tax efficiency of debt funds has also been a draw. Investors who have moved from bank deposits to debt mutual funds that take on credit risk have witnessed multiple shocks over the past few years. The most recent one is the Franklin Templeton MF winding up six funds.

In times of uncertainty due to the Covid-19 pandemic, where many people are trying to keep their savings safe, the SLF-MF is a confidence-inspiring measure for the mutual fund industry and for bond markets. It shows that RBI is ready to do “whatever it takes” to support the financial sector in its hour of need.

The bottomline

The RBI is willing to step in to resolve systemic issues, but draws the line at taking risks off market players’ books.

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Published on May 05, 2020

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