Why do Indian mutual funds intermediate inter-bank lending?

The Reserve Bank of India’s Report on Trends and Progress in Banking in India 2009-10 contains an interesting discussion on the inter-linkages between banks and debt mutual funds (Box IV.1 on page 64). As of November 2009, banks had invested Rs 1.3 trillion in debt mutual funds, but had also borrowed Rs 2.8 trillion from these funds – banks were thus net borrowers to the extent of over Rs 1.5 trillion. It appears that debt mutual funds are intermediating two kinds of flows in the debt market.

1. Debt mutual funds were intermediating Rs 1.5 trillion of debt flows to the banks largely from the corporate sector.
2. More interestingly, debt mutual funds were also intermediating Rs 1.3 trillion of interbank lending.

The RBI report describes the intermediation of interbank lending as follows:

When banks were arranged in a descending order by the amount of their net borrowings from MFs, public sector banks figured prominently at the upper end as major borrowers, while the new private sector banks along with SBI could be seen as major lenders to MFs.

The interbank money market is one of the oldest and most liquid markets in India. The repo market for secured lending is also well established with a central counterparty for risk mitigation, and has worked smoothly even during the turbulent periods of 2008. Why would there be a need for mutual funds to intermediate this market? Two possible reasons come to mind.

1. The intermediation may be happening largely due to the tax advantages of mutual funds.
2. The mutual funds may be intermediating the interest rate risk involved in investing in certificates of deposit issued by banks with several months of residual maturity, while allowing their own investors to redeem at any time. In the ultimate analysis however, this is an illusion because a mutual fund does not absorb risks, it only passes these risks on to its investors. Since the primary non-bank investors in a debt mutual fund come from the corporate sector, the question is whether the corporate sector has superior ability or willingness to assume this risk. I think the answer is no; in times of stress the corporate sector has been desperate to bail out of mutual funds. In 2008, it was left to the government to bail out the mutual funds themselves.

It appears to me that the whole system of artificial tax breaks to mutual funds has created economically useless layers of intermediation while also adding to systemic risk and fragility.

Posted at 1:52 pm IST on Mon, 15 Nov 2010         permanent link

Categories: banks, mutual funds

Comments