How the COVID-19 Extended Lockdown Has Made Investments in ‘Banking Funds’ Very Risky

Besides, as people are confined to their homes, lower demand for goods and services has further impacted cash flows. The decline in cash flows will affect the firms' ability to make payments towards loan principal, interest, and taxes.

Moreover, with businesses impacted, many individuals risk being laid off or face delayed/reduced salary payments, especially those in trade, tourism, airlines, hospitality, and construction sector. With their incomes affected, these people may find it difficult to stick to their EMI and loan repayment schedule.

Hence, the financial implication of the pandemic could be severe. Non-performing assets could pile up in a financial system already marred by the existing burden of high bad loans.

In its continuing effort to maintain adequate liquidity in the system, facilitate bank credit flows, and ease financial stress in the face of COVID-19 related disruptions, RBI on April 17 came out with additional measures.

Earlier,the RBI had introduced long-term repo operation (LTRO) to ensure adequate liquidity at the longer end of the yield curve. However, banks used the liquidity availed under this to invest in bonds issued by public sector entities and large corporates.

The disruptions caused by COVID-19 have, however, impacted small and mid-sized corporate more severely, including non-banking financial companies (NBFCs) and micro finance institutions (MFIs), in terms of access to liquidity.

Thus, RBI will conduct Targeted LTRO for an aggregate amount of Rs 50,000. The funds availed under this will have to be invested in investment grade bonds, commercial paper, and non-convertible debentures of NBFCs, with at least 50% dedicated towards small and mid-sized NBFCs and MFIs.

Secondly, RBI has lowered reverse repo rate by 25 bps to 3.75 and reduced liquidity coverage ratio to 80% from 100% to encourage banks to invest surplus funds in investments and loans in productive sectors of the economy rather than parking ìt with RBI.

Thirdly, for accounts where RBI had earlier asked to provide moratorium on loan repayment, and which where standard as on March 1, 2020, banks will exclude such accounts from being classified as NPA till May 31, 2020. NBFCs will have the flexibility to provide such relief to borrowers under the guidelines prescribed under the applicable accounting standards.

Furthermore, NBFCs with exposure to construction segment had asked for some relief from RBI as the sector has been one of the worst affected by the lockdown. RBI has said that in respect of loans to commercial real estate projects delayed for reasons beyond the control of promoters can be extended by an additional one year, over and above the one-year extension permitted in normal course, without treating the same as restructuring.

Could this be enough to help Banks and NBFCs sail through the crisis?

RBI's move is a welcome step in the right direction and can provide some relief to banks and NBFCs, though it could hit a few roadblocks...

With business operations halted and millions of jobs at risk, default risk in India could heighten.The moratorium provided to borrowers can delay the good loans from turning into bad. However, if even after the moratorium if lenders are not able to recover the amount, banking and finance sector may become overwhelmed with financial stress.

Many of the existing loans may slip into non-performing assets and recovery may become difficult.Moreover, Banks may be reluctant to lend to such affected firms and individuals leading to subdued credit growth.

Lower lending growth, higher provisioning, and slow resolution of bad loans will affect the profitability of Banks and other financial institutions and put the financial system under adversity.

Therefore, I expect banking and finance stocks to be highly volatile in the next couple of quarters. Only those with low bad debt and low concentration of loans towards affected sectors may fare well during this period.

How will it affect your mutual fund investment?

Most diversified equity funds have significant exposure to Banking and Finance stocks. Equity funds exposure to Banking stocks average around 16% while that towards Finance stocks is 9%. Thus you may expect performance from your equity funds to be subdued in the coming months.

That said, RBI expects India to post a sharp turnaround and resume its pre-COVID, pre-slowdown trajectory by growing at 7.4 per cent in 2021-22. The banking and finance sector, which is an important indicator of economy's health, could be at the forefront of this growth.

Hence, the expectation of strong recovery makes it worth holding on to banking and finance exposure through an actively managed and worthy mutual fund with a long term perspective.

Taking exposure through banking and financial services fund is not advisable because sectors go through lots of ups and downs over different time periods. It prevents you from taking diversified exposure in other sectors that may be performing better and caps your overall returns.

Therefore, invest in worthy mutual funds that are well-diversified across stocks and sectors. The 'Core & Satellite' approach to investment is one of the most trusted approaches when investing in a diversified portfolio of equity funds.

If you wish to invest in a readymade portfolio of top recommended equity mutual funds based on the 'Core & Satellite' approach to investing, I recommend that you subscribe to PersonalFN's Premium Report, "The Strategic Funds Portfolio For 2025 (2020 Edition)".

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Warm Regards,
Divya Grover
Research Analyst

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