The Covid-19 outbreak has led to heightened volatility in capital markets and intensified redemption pressures to bring some mutual funds to a point of closure. To ease the liquidity burden, the RBI has stepped up its efforts to save mutual funds from closure by allocating Rs 50,000 crore towards special liquidity facility, a move made to address high-risk mutual funds in particular.
Last week, Franklin Templeton announced the closure of six funds namely — Franklin India Low Duration Fund (FILDF), Franklin India Credit Risk Fund, Franklin India Dynamic Accrual Fund, Franklin India Ultra Short Bond Fund, Franklin India Short Term Income Plan, and Franklin India Income Opportunities Fund (FIIOF) effective from April 23. Total assets under management of these funds are estimated to be around Rs 25,000 crore. There is a spill-over effect of the closure of these funds on banks, other liquid funds and equity markets as well.
These closures have shaken investor confidence in the mutual funds' industry, with the possibility of likely redemption wherein the money would go to banks till the time they get some clarity.
What does the Special Liquidity Facility for Mutual funds (SLF-MF) entail?
According to the RBI announcement, "The SLF-MF is on-tap and open-ended MFs, and banks can submit their bids to avail funding on any day from Monday to Friday (excluding holidays). The scheme is available from today i.e., April 27, 2020, till May 11, 2020, or up to utilization of the allocated amount, whichever is earlier. Under the SLF-MF, the RBI shall conduct repo operations of 90 days tenor at the fixed repo rate. The RBI will review the timeline and amount, depending upon market conditions."
While banks will decide the tenor of lending to /repo with mutual funds, the minimum tenor of the repo with RBI will be for a period of three months. This move by the RBI will help soothe the increased tension in the mutual fund industry and help regain investor confidence, perhaps a modified extension of Targeted Long Term Repo Operations (TLTRO) for a short term of 3 months (90 days) rather than a year or three years, catering to specific pain points in the MF industry.
Funds availed by banks under the SLF-MF can be used for extending loans, undertaking outright purchase of and/or repos against the collateral of investment-grade corporate bonds, commercial papers (CPs), debentures and certificates of Deposit (CDs) held by MFs.
Explaining the rationale behind the SLF-MF facility
As this facility extends support to mutual funds, it shall be exempted from banks' capital market exposure limits. Also, exposures under this facility will not be reckoned under the Large Exposure Framework (LEF). This facility announcement by the RBI will boost confidence and reduce the yield volatility as witnessed in the corporate debt market.
The RBI announcement clearly stated that "The liquidity support availed under the SLF-MF would be eligible to be classified as held-to-maturity (HTM) even in excess of 25 per cent of total investment permitted to be included in the HTM portfolio. The face value of securities acquired under the SLF-MF and kept in the HTM category will not be reckoned for computation of adjusted non-food bank credit (ANBC) for the purpose of determining priority sector targets/sub-targets."
The SLF-MF facility will help reduce redemption pressures faced by MFs, to facilitate borrowing from banks at a lower cost in comparison to their banking lines. Similar liquidity support was issued by RBI in 2008, which saw limited utilisation but it proved to be a confidence booster back then. The SLF scheme makes sense for banks - as they can borrow at 4.4 per cent from the RBI and lend at 2 to 2.5 per cent margin.
Besides redemption pressure, the mutual fund industry is also faced with a risk aversion issue. If the SLF is restricted to credit risk funds and other such funds that have a higher share of lower-rated assets, then the liquidity facility in itself will not help solve the risk aversion issue.
The collateral requirement in the form of securities as per the funding scheme, may not meet the banks' criteria. Only if banks were ready to take these securities as collateral, then they would prefer buying them in the secondary market under TLTRO operations to help the credit risk funds meet redemptions. While the SLF window can be used for an outright sale of securities, it brings to question the issue of credit risk aversion of banks.
For now, allocation of funds under SLF-MF is a temporary relief measure for the mutual funds' industry and investors by all means, but RBI has to be cautious to observe if this move does not cause any build-up of leverage that cannot be sustained for long.