Almost 90% of the funds parked by banks in mutual funds (MFs) come back into banks in the form of overnight borrowings through various channels. Though the issue of circular investments between banks and MFs has been discussed in public domain for several months now, the Reserve Bank of India has, for the first time, put it in the public domain data pointing to the extent of such circular trade.
According to the latest data, banks parked Rs 66,687 crore in MFs as of September 25, 2009. These investments are essentially in debt and liquid schemes. MFs, in turn, have lent Rs 29,504 crore under the collateralized lending and borrowing obligation (CBLO) platform and Rs 29,328 crore under market repo, respectively.
The CBLO is a facility which allows non-banks to lend to banks short-term surpluses. MF lending through CBLO and market repo as a percentage of banks’ investment in mutual funds has gone up from about 64% in July to 88% in September.
MFs also subscribe to commercial paper issued by corporates, which is tantamount to lending to corporates by MFs. This lending is ostensibly from funds raised from banks, which are the largest investors in debt MFs. The Reserve Bank has objected to such indirect lending by banks through intermediaries as MFs may lend to corporates that banks themselves have rejected and pose a regulatory concern.
But more serious is its concern over the circular investment between MFs and banks. In an interview to ET on Tuesday, the Reserve Bank governor, D Subbarao said,"... there is concern over the circularity in the movement of liquidity in the system. We have requested banks to take the issue to their board, discuss it at their senior management level and have some governance norms for their investment in debt mutual funds. They must also discuss in their club, the IBA (Indian Banks’ Association) and act as a self regulator."
Though the IBA still has to receive any formal communication from the central bank on this matter, a senior official explained the rationale behind RBI’s concerns on the condition of anonymity.
"As for banks, they earn 3.25% by parking surplus funds with the Reserve Bank. However, they have to pay the corporate income tax of 30% on the income. One ends up losing about 90 bps (basis points 1 bps= 0.01%). Whereas, income from mutual fund is tax-free., even if the returns by deploying the funds in MF is 50 bps low and then borrowing it again through CBLO, the bank still ends up making more income. However, this could pose a systemic risk in case of sudden unwinding of liquidity."
Speaking on the subject of links between banks, MFs and NBFCs, former RBI governor YV Reddy said in a speech last week: "It is also noteworthy that some mutual funds and NBFCs have close affiliations with large corporates or banks. No doubt, there could be what may be technically termed as fire walls, but a detailed study of their interlinkages, actual operations in concert or clusters with each other and in the equity and corporate bond markets would help reassurance that serious conflicts of interests with systemic consequences are not pervasive."
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