The Reserve Bank of India's (RBI's) support measures for mutual funds may struggle to be effective, as low-capitalised banks are unlikely to extend liquidity to the sector without capital relief on the facilities, says global rating agency Fitch.

Following the Franklin Templeton debacle, the Reserve Bank of India (RBI) on April 17 announced a Rs 50,000 crore special liquidity facility (SLF) for mutual funds to ease pressure on mutual funds, which are facing liquidity crisis amid heightened volatility in capital markets in reaction to COVID-19 outbreak.

Fitch said that the size of the SLF-MF appears broadly commensurate with the scale of the funds most at risk.

"The success of the SLF-MF will hang on banks' appetite to take up the risks involved, against the system-wide backdrop of low capital headroom and a likely increase in fresh non-performing loans," the rating agency said.

The facility's structure places the onus on banks to absorb the associated credit and capital risk, which may hinder their willingness to participate, it added.

Fitch feared that if the liquidity facility does not achieve its aims of supporting liquidity or restoring market confidence, more debt schemes will be forced to suspend redemptions, also known as 'gating'.

According to the agency, the funds classified as "credit risk funds" are most at risk if redemptions continue (their AUM declined by 10% in March), particularly where funds have exposure to less liquid securities, such as unlisted securities, and/or have demonstrably higher risk appetite through exposure to defaulted entities such as IL&FS, Religare Finvest, and Dewan Housing.

Fitch said that liquidity mismatch is most acute in mutual funds investing in illiquid assets such as property. "An interruption of, or reduction in, funding provided by mutual funds to major entities or sectors, due to outflows or redemption suspensions, can have material credit implications for entities more reliant on wholesale funding," it said.

The funding conditions for Indian non-bank financial institutions (NBFIs) also remained challenging amid the tighter debt market conditions of the past two years, Fitch said. "If the RBI's support measure fails to restore market confidence, leading to intensified redemption pressures for other funds, this could further narrow funding options for the sector," it added.

In March, Indian open-end mutual funds saw aggregate outflows of almost 20%. Within this, overnight funds, the most conservative variant in India, saw assets jump by almost 50%, whereas most other fund types saw outflows.