MUMBAI : Liquid funds may soon be allowed to invest only up to 30% of their assets in securities issued by non-banks and mortgage lenders, as the market regulator seeks to reduce the sectoral risk faced by these funds.

The Mutual Fund Advisory Committee (MFAC) of the Securities and Exchange Board of India (Sebi) on Wednesday proposed that the exposure limits of liquid funds to non-banking finance companies (NBFCs) and housing finance companies (NBFCs) be reduced in a phased manner, three people aware of the matter said.

Banks’ refusal to lend has triggered a cash crunch at NBFCs, in turn raising concerns that they will struggle to repay liquid funds that have bought their debt papers.

Currently, liquid funds can have an aggregate 40% exposure to these lenders, including 25% to NBFCs and 15% to housing finance companies.

The committee has proposed to initially reduce NBFC and HFC exposure to 22.5% and 12.5%, respectively, and finally to 20% and 10%.

“The exposure to NBFCs including HFCs can go up to 40%. But considering the liquidity crisis in NBFCs and HFCs, a high exposure can further lead to redemption pressure and liquidity crisis for liquid funds. Bearing that in mind, the exposure will be brought down to 30% in a phased manner," said one of the three people quoted above, all of who spoke under condition of anonymity. The committee will submit its final report on 2 July.

As these limits are tightened, more money from liquid funds may flow into commercial paper from other sectors of the economy and treasury bills issued by the government.

This move comes amid heightened investor concerns about liquid funds holding debt issued by troubled groups such as Infrastructure Leasing & Financial Services Ltd (IL&FS), Dewan Housing Finance Ltd and Essel Group. It is mainly large organizations and corporate entities which invest in liquid funds to park their temporary surpluses.

Interestingly, a significant share of fresh investor flows in May 2019 went into overnight funds, which invest in paper maturing overnight, which have minimal credit and interest rate risk.

This category may eventually become a significant alternative for liquid funds. The committee further proposed that all papers held by liquid funds should be marked to market. Currently, paper above 30 days’ maturity is required to be marked to market.

These measures are likely to bring additional transparency in debt security pricing and reduce the risk in this category of mutual funds. The committee has also suggested a code of conduct for rating agencies for better valuation of thinly traded securities, the second of the three people quoted above said.

“Mutual funds tend to rely heavily on rating agencies. In many cases, the rating agencies do not follow standard or uniform norms in instances of thinly traded securities. One way to avoid it is to have a polling framework for valuation of thinly traded securities," said this person. India’s 25.93-trillion mutual fund industry which has lent to NBFCs has received particular attention in the crisis, with questions being raised on the safety of 13.24 trillion of assets under management (AUM) of debt funds. Mutual funds continue to have a massive 3.12 trillion exposure to NBFCs and HFCs.

The committee has also proposed a 10% cap on the extent of debt fund exposure to so-called credit-enhanced securities.

A credit enhancement is typically a promoter guarantee or the offer of shares as collateral in order to enhance the creditworthiness of specific debt paper. These are also referred to as loan against share (LAS) papers.

These papers came under scrutiny after the standstill agreement between mutual funds and Essel promoters, under which fund houses agreed not to sell the underlying shares of Essel promoters till September 2019. A fund manager, who did not wish to be named, said that the mutual funds typically limit credit-enhanced security exposure at 30% of the fund’s corpus. The mutual funds industry currently has a roughly 50,000 crore exposure to loans against shares, a form of credit enhancement.

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