MFs hold as high as 40% in cash in liquid schemes to manage volatile flows from banks
Mumbai: In the fortnight ended November 19, 2010, investments by banks in mutual funds rose by Rs 17,000 crore, contrary to belief that banks are short of liquidity. A fortnight earlier, banks’ investments in mutual funds had fallen by a sharp Rs 21,000 crore.
The quick change in liquidity conditions in the banking system has resulted in volatility in banks’ investments in mutual funds. The large fluctuation in investment flows from banks into mutual funds puts extra pressure on fund managers to hold higher amount of liquidity to meet any spike in redemptions. The cash holding in some of the liquid funds has been as high as 40 per cent.
“We try to keep a high amount of cash and cash equivalents. We keep the liquid funds maturity very short and vary the cash level depending on the percentage of money from the banks. As a thumb rule most funds keep 25 to 40 per cent cash in these funds to ensure that all the liquidity requirements are met,” said Mahendra Kumar Jajoo, Executive Director, Fixed Income, Pramerica Mutual Fund.
The volatility of flows from banks into mutual funds has become a cause of concern for the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI). Any failure of mutual funds to meet redemption demand could have a cascading effect on the financial system. There are talks that RBI and SEBI might issue guidelines for the banks and mutual funds respectively to check any threat to the financial system.
Banks investments in mutual funds as on November 19, 2010 were Rs 45,530 crore against Rs 1, 65,441 crore a year earlier.
“We have seen so many changes in the last five years. These things have only strengthened and improved the mutual fund industry. If the risk is diversified, it is good for the banks and the mutual funds. It would be a good move if the RBI and SEBI seek to regulate flows,” said Jajoo.
According to recent media reports, the Prime Minister’s Economic Advisory Council Chairman, C Rangarajan, cautioned banks against relying heavily on mutual funds to raise money due to their volatile nature. "Funding provided by mutual funds can be volatile (as) the bulk of bank CDs has a maturity of three months or less," he was quoted by PTI in a report on December 5, 2010.
The reason why Rangarajan cautioned banks is that mutual funds in turn also invest in certificates of deposit issued by banks. Mutual funds’ investments in CDs of banks amounted to Rs 2, 01,207 crore at the end of October 2010, which was 47.55 per cent of the total assets under management in debt schemes. Banks issue CDs to raise funds for up to one year.
Banks usually invest in liquid and liquid plus schemes. Some banks even invest money borrowed from the overnight markets in mutual fund schemes. Liquid fund schemes normally offer 4-6 per cent returns. This is possible when the banks’ cost of borrowing is lower. In turn, mutual funds also in CDs issued by banks.
It is also a case of circular flow of funds between banks and mutual funds. Any liquidity crisis in one segment would have the potential of hitting hard the other segment and thereby escalate the risk to the entire financial system.
