Banking regulator, RBI, has questioned banks on steps adopted by them to reduce exposure in mutual funds.

Earlier this week, RBI wrote to all banks asking them about their exposure in mutual funds and the steps adopted by them to decrease such exposure.

RBI governor, D Subbarao, expressed concerns over banks' huge mutual fund exposure. Approximately 90 percent of the money invested by the banks in mutual funds comes back to them in the form of borrowings from the overnight money market.

RBI termed this as ‘circular trading' and directed banks to set an internal limit approved by the board. It also asked for exposure details in mutual funds for March-September 2009 period and the present exposure.

RBI had asked banks to improve their corporate governance norms related to investments in mutual funds. In the meeting with bank CEOs, the RBI governor had said that regulators would avoid fixing an upper limit for banks' investment in mutual fund since it might lead to micro management.

Banks are seen as valuable customers by the mutual fund industry because they constitute almost one-thirds of their total fixed income assets. Most banks have set an internal limit in the range of 5-20 percent of their investment portfolio.

However, Recent RBI data shows that despite RBI's warning, the total investments by the banking sector in mutual funds have increased in November.

According to the latest RBI data, banks' investments in MF schemes rose Rs 4,173 crore to Rs 1,64,656 crore during the fortnight ended November 20. Banks claim that investment in mutual funds is largely due to lower demand for credit.