The Reserve Bank of India (RBI) announced a Rs 50,000 crore special liquidity facility for mutual funds as redemption pressure increased after Franklin Templeton closed six debt mutual funds last week. With assets worth more than Rs 86,000 crore as of the end of March, Franklin Templeton is the ninth-largest mutual fund in the country, set up over two decades ago.

“Due to the on-going novel coronavirus or COVID-19, pandemic, liquidity in the bond market has dried up. Yields of debt securities have risen sharply and that has materially diminished the abilities of companies to service their debt. Mutual funds have also been getting a lot of redemption requests by the investors. We felt it best under these circumstances to wind up these funds and return the money to investors,” Sanjay Sapre, President, Franklin Templeton – India, said.

The modus operandi of the RBI arrangement is as follows:

  1. RBI will provide a special liquidity facility to banks to lend to mutual funds.
  2. Funds availed under the liquidity facility shall be used by banks exclusively for meeting the liquidity requirements of mutual funds. Banks need to give government securities as collateral to RBI. They will borrow from the RBI at the repo rate.
  3. Banks can extend loans to mutual funds, or they can outright buy corporate bonds or commercial papers from them.
  4. This lending facility is available for the next 3 months
  5. There are some additional clauses, like banks not having to report such bonds as "non priority sector" exposure or "large" exposures.

Implications of this modus operandi

Under this arrangement, defaults by mutual funds will be the risk of the bank, not of RBI. As usual the RBI has not assumed credit risk. Furthermore, there are some caveats for the mutual fund companies as well.

The good corporate bonds - like REC/NTPC bonds - can be bought by a bank and it would provide the equivalent liquidity to the mutual fund. However, when the bank lends money to the mutual fund at say an 8% interest rate, then there is a problem. If the yield of the fund is 6%, the mutual fund will pay that interest to the bank. However, the remaining 2% would have to be borne by the asset management company itself. A tough ask in these uncertain times.

These measures should go a long way in giving confidence to fearful investors who are redeeming money not on account of credit quality concerns, but a fear that all asset management companies will also shut down their respective credit funds.

While 50,000 crores certainly provides a lifeline, it is not clear how many AMCs would require the money, and whether this amount would be sufficient to contain a potential crisis.