February 9th, 2010 
Tushar Mathur
Heightened scrutiny by India’s central bank on debt investments by the country’s banks will take a toll on the domestic mutual fund industry’s asset growth, with banks set to shrink their fund holdings.
In recent weeks, the Reserve Bank of India has ratcheted up its rhetoric on the potential risk posed by the so-called circular trade between banks and mutual funds, where banks invest excess cash in debt funds while fund houses use a large portion of these debt fund proceeds to invest in banks’ certificate of deposits.
The central bank, in a private note issued to banks has asked banks to act as “self regulators” on their debt fund investments, three people familiar with the matter had told Dow Jones Newswires in mid-December.
Certificates of deposits are short-term instruments used by banks to raise funds.
While banks generally cut their mutual fund assets exposure at the end of each quarter to meet capital adequacy requirements, industry experts expect future data to show that the RBI’s moral suasion is having some impact.
Mutual fund assets in the quarter ended Dec. 31 were down 19% at 6.65 trillion rupees ($143.7 billion) from a record high of 8.22 trillion rupees at the end of November. However, the funds are generally reinvested in the beginning of the following month.
“Some of the investments (by banks into debt funds) may not come back. We are already seeing that in January the amount of money coming back is lower,” U.K. Sinha, chairman and managing director of UTI Mutual Fund, India’s oldest and fourth largest fund house.
Bank investments into mutual funds rose to as high as 1.69 trillion rupees as of Dec. 4 from 319.20 billion rupees in late December 2008, data from the central bank shows. Debt fund assets–which include income funds and liquid/money market funds–make up the bulk of the banks’ investments and accounted for 66% of the mutual fund industry’s total assets at the end December.
Even though the RBI has not issued a prescriptive directive on the issue, the central bank’s exhortations to banks to self-regulate could well spur a further downsizing of bank’s inflows into debt fund schemes, some bank treasury officials and industry experts said.
At least four fund managers and bank treasury heads who declined to be named said in total, debt mutual funds held by India’s banks could shrink by between 30% and 40%.
“There’s always the risk that if banks don’t scale back, the RBI may do something drastic such as changing the capital adequacy norms to a period-average basis, from the current ‘end of the quarter’ basis,” said Ashutosh Khajuria, treasury head at IDBI Bank, noting that banks will prefer to cut debt fund holdings than risk a showdown with the country’s central bank.
For its part, the RBI’s concern is the interdependence of banks and mutual fund houses in India.
Banks’ dependence on certificates of deposits purchased by mutual funds poses a significant rollover risk which banks must be mindful of, RBI deputy governor Usha Thorat said recently. Banks, meanwhile, tend to withdraw liquidity en masse, increasing the danger of a run on mutual fund assets, Ms. Thorat noted.
The increased central bank scrutiny comes at a time when banks, despite a recent revival in credit, are flush with deposits and cash, meaning that the limitations on debt fund investments may force banks to increase lending, affecting risk. Otherwise, banks may deposit a larger amount of cash in low-yielding central bank reverse repo window, a move that would affect earnings.
Under the reverse repo window, banks park their surplus cash with the central bank at the overnight rate of 3.25%.
After dipping to as low as 9.5% in late October, loan growth for Indian banks rose 13.9% year-on-year in the two weeks ended Jan 15. It, however, lagged the 16.8% growth in deposits, and still remains below the RBI’s twice-reduced forecast of 16% growth for the fiscal year.
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