Change In RBI Rules Could See More Bank Money Flowing Into Debt Mutual Funds

A change in the Reserve Bank of India’s guidelines on capital adequacy for banks could potentially result in them investing more into debt mutual fund schemes and exchange traded funds.

In a notification on Thursday, the central bank said it had decided to “harmonise the differential treatment existing currently” on the capital charge attracted under Basel III norms for investments by banks into a debt instrument directly compared with an investment into the same debt instrument through a mutual fund or exchange traded fund.

Basel III norms on capital adequacy require banks to have a certain amount of capital so that they can absorb losses in loans advanced or investments made. Under norms so far, a bank would be required to allocate lower capital when investing directly into a debt instrument rather than through a mutual fund or ETF.

“So up until now, debt funds were classified from a capital adequacy perspective, very similar to equity funds or equity securities,” said R Sivakumar, head of fixed income at Axis Mutual Fund. “It had a very significant capital charge and consequently banks would typically not invest for long periods of time in fixed income mutual funds.”

With the new change, the RBI, according to Sivakumar, has effectively ensured the capital charge will be applicable based on the quality of the underlying portfolio with some market risk added on. This makes debt funds more attractive for banks, because the penalty of a very high capital charge is removed, he said.

According to the RBI notification, the risk capital charge on investments into debt mutual funds and ETFs, which hold a mix of central, state and foreign central government bonds, bank bonds, and corporate bonds, will be computed based on the lowest rated debt instrument. The investment will also attract a general market risk charge of 9%.

Immediate Impact

The immediate impact of the change in norms will be on the durability of banks’ investments on the short end of the debt mutual fund investment spectrum. Banks typically invest in shorter-term fixed income schemes of mutual funds as a tool to manage surplus liquidity. But because of the high capital charge associated with such investments so far, there would be a significant amount of churn in mutual fund assets under management at the end of a quarter.

“You’ve seen this phenomenon of bank money moving out of mutual funds at quarter ends which is typically when capital adequacy is reckoned,” said Sivakumar.

The lower charge could likely result in banks being more comfortable parking money in the shorter-end mutual fund schemes.

Deepening The Bond Market

A longer term objective of the RBI, which might also get fulfilled is the deepening of the bond market.

“Banks haven’t been very excited about long-term investment in the fixed income side of mutual funds,” said Swarup Mohanty, chief executive officer at Mirae Asset Investment Advisers. “Prima facie, this could change that, and a category like the corporate bond fund could become more attractive for banks.”

But banks could just as easily focus on their lending business to deploy surplus liquidity, he said.

“We’re very happy that the RBI has chosen to harmonise risk weights in particular on Bond ETFs,” said Radhika Gupta, managing director and chief executive officer at Edelweiss Asset Management, which manages the Bharat Bond ETF. “This will make the asset class more attractive for banks, and in the long term only aid liquidity and development of the bond market.”