Indian mutual funds, which are reeling under the impact of a raft of measures including a ban on charging entry load imposed by the securities market regulator Sebi, now face the threat of an erosion in the assets they manage. On Tuesday, the banking regulator- the Reserve Bank of India (RBI) - dealt a body blow to the industry which manages assets of over Rs 7,00,000 crore by directing banks to cap their investments in the liquid schemes of mutual funds at 10% of the banks' net worth in six months.

The RBI directive will dampen the cosy relationship between banks and mutual funds, which has been a cause of concern for the central bank in recent months. Banks park their surplus money in liquid schemes, which invest in debt securities of duration less then a year, including banks' certificates of deposits, companies' commercial papers, treasury bills and the collateralised lending and borrowing obligation or CBLO market, for quick returns.

These funds, in turn, lend to banks in the overnight CBLO market. Mutual funds are also among the major investors in banks' certificate of deposits.

Banks' investment in mutual funds aggregated Rs 1.11 lakh crore on April 6 against Rs 70,999 crore on January 14, according to RBI. Fund managers said over 80% of banks' money in mutual funds is in liquid schemes. The investment restriction will limit banks' surplus money coming into mutual fund schemes at Rs 30,000 crore. The total net worth of the banking system is around Rs 3.13 lakh crore as March 31, according to fund managers.

So, mutual funds can expect to face redemptions of almost Rs 60,000 crore over the next six months. "Such circular flow of funds between banks and DoMFs (debt-oriented mutual funds) could lead to systemic risk in times of stress or liquidity crunch.

Thus, banks could potentially face a large liquidity risk," RBI said in the circular. The latest regulatory measure will reduce the dependence of mutual funds on banks and viceversa , said Ritesh Jain, head--investments , Canara Robeco Asset Management.

"This will end an era of easy money for mutual funds and banks, which will be forced to look more closely at the conventional route of raising money through retail fixed deposits," Jain said. "This once again emphasises the fact that going retail is the way to build mutual fund assets ," said A Balasubramanian, chief executive officer, Birla Sun Life Asset Management Company.

Fund managers said the restriction will result in short-term rates -- 3-12 months -- turning volatile , with lesser money flowing into such instruments . "Assuming that interest rates are expected to remain firm till October, the shortend of the curve will turn steeper because of lesser liquidity," said the chief investment officer of a bank-owned mutual fund.