RBI's liquidity support for MFs may struggle to be effective: Fitch

The Reserve Bank of India's (RBI's) liquidity support for mutual funds could struggle to be effective, as its success would hang on banks' appetite to take up the risks involved, amid a low capital headroom and a likely increase in fresh non-performing loans, according to Fitch.

The RBI's Rs 50,000-crore Special Liquidity Facility for Mutual Funds (SLF-MF) will provide a 90-day repo funding to banks, to extend liquidity to — or purchase of commercial paper and debt securities from — local mutual funds.

The size of the SLF-MF appears broadly commensurate with the scale of the funds most at risk, Fitch notes.

"The official support measures announced for mutual funds in India may struggle to be effective, as undercapitalised banks are unlikely to be tempted to extend liquidity to the sector without capital relief on the facilities," Fitch Ratings said in a statement.

The facility's structure placed the onus on banks to absorb the associated credit and capital risk, which might hinder their willingness to participate, it added.

The move by the banking regulator followed the suspension of redemptions in six Franklin Templeton bond funds, with combined assets under management (AUM) of approximately $4.1 billion equivalent, on April 23, 2020, and outflows from other funds in March 2020.

Fitch further said that "the success of the SLF-MF will hang on banks' appetite to take up the risks involved, against the system-wide backdrop of low capital headroom and a likely increase in fresh non-performing loans.".

Indian open-ended mutual funds saw aggregate outflows of almost 20 per cent in March. Within this, overnight funds, the most conservative variant in the country, saw assets jump by almost 50 per cent, whereas most other fund types saw outflows.

"Fitch believes funds classified as "Credit Risk Funds" are most at risk if redemptions continue (their AUM declined by 10 per cent in March), particularly where funds have exposure to less liquid securities, such as unlisted securities, and/or have demonstrably higher risk appetite through exposure to defaulted entities such as IL&FS, Religare Finvest, and/or Dewan Housing," it said.

Fitch said Mutual funds form a conduit between retail and institutional investors and financial markets. Most mutual funds assume liquidity risk, through offering investors the ability to redeem daily, while investing only a limited portion of their portfolios only in risk-free assets or cash.

This liquidity mismatch is most acute in mutual funds investing in illiquid assets such as property. An interruption of, or reduction in, funding provided by mutual funds to major entities or sectors, due to outflows or redemption suspensions, can have material credit implications for entities more reliant on wholesale funding.