Fitch fears more 'gating' in debt schemes if RBI plan doesn't take-off

Banks may look at conserving capital, with asset quality concerns rising amid Coronavirus-induced lockdown

The global rating agency Fitch says under-capitalised banks may steer clear of extending liquidity support to debt mutual funds (MFs) through Reserve Bank of India’s (RBI) window.

This could force more debt schemes to move to suspend redemptions, also known as 'gating', one of the calls taken by Franklin Templeton Mutual Fund.

“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,” the agency said.

The agency pointed out that the success of the standing liquidity facility (SLF-MF) will depend upon banks’ appetite to take up the risks, against the system-wide backdrop of low capital headroom and the likelihood of rising non-performing assets (NPAs) due to slowdown in economic activity.

To be sure, there are three modes in which banks can offer liquidity to mutual funds. One is by extending loans and the other is buying out the debentures or commercial papers held by the mutual funds. However, banks may be less willing to take credit risks on their books, according to market participants.

The other route is by offering credit against collateral of investment grade corporate bonds, commercial papers (CPs), debentures and certificate of deposits. However, experts say if a scheme is in need of liquidity, it is likely that it has lower-quality papers, which may not meet banks’ criteria for a collateral.

Fitch said credit risk funds are most at risk if redemptions continue, particularly where funds have exposure to less liquid securities, such as unlisted securities, or have demonstrably higher risk appetite through exposure to defaulted entities such as IL&FS, Religare Finvest or Dewan Housing.

It said that the liquidity mismatch remains more acute in schemes that have exposures to sectors such as real-estate or those dependent on whole-sale funding. The spike in redemption pressure for debt MFs can create a negative feedback loop leading to funding constraints for capital-hungry sectors such as non-bank financial companies (NBFCs), which count debt MFs as a source of funding.

The recent issues in Franklin have also underlined the mismatches in an open-end credit scheme, where underlying faced liqudity risks, but investors are offered a product where daily redemptions are allowed. 

At the end of March, several debt schemes had reported negative cash balances, as they were forced to borrow from banks to meet high redemption pressure. Selling securities in market became difficult due to illiquidity amid Coronavirus-induced lockdown. In March, debt schemes saw outflows of Rs 1.9 trillion, highest for any fiscal-end closing.  

However, industry says their borrowing has reduced significantly in April. The Association of Mutual Funds in India pointed out that the industry’s borrowing had declined to Rs 4,427 crore as of April 23, 2020.