HDFC Bank-HDFC merger: India’s markets regulator is unlikely to give special exemption to mutual funds if they breach the norms for maximum permitted holdings in a security after the merger of HDFC Bank and HDFC, two sources with direct knowledge of the matter told Reuters. HDFC Bank and HDFC - both heavily owned by mutual funds - are set to conclude a merger in the next few weeks to create India's second-largest financial institution by assets after the State Bank of India. However, pressure on mutual funds to reduce their holdings or any limitations on increases could be an overhang on the stock of the merged entity.

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As per the rules of the Securities and Exchange Board of India (SEBI), a mutual fund scheme cannot invest more than 10% in a single security. However, exchange-traded funds and funds that invest in particular sectors are exempt. At least 60 equity mutual fund schemes will see their combined exposure to HDFC Bank and HDFC overshoot the 10% cap as of Wednesday.

HDFC Bank and SEBI did not reply to emailed requests for comments.SEBI could consider this overshoot as a "passive breach," implying no deliberate attempt to flout rules, one of the sources said. In such cases, the funds have 30 days to rebalance their portfolio, which can be extended by another 60 days, failing which the mutual funds may face regulatory action, the source added. Regulatory intervention is warranted if there is a wider impact on the market, which is not the case here, said the second source.

Both sources declined to be named as they are not authorised to speak to the media.The matter has been referred to the Association of Mutual Funds in India (AMFI), according to two mutual fund executives. Last week, AMFI officials and industry executives analysed the impact of the merger and how much of the stock the industry would need to sell to adhere to regulatory limits, the executives said.

"Considering the regulatory requirement, there will be some mutual funds that would need to sell which will create short-term pressure on the stock. However, with the prices reducing, it will create more opportunities for retail and other domestic investors to buy," said Deven Choksey, founder of KRChoksey Holdings Ltd, a brokerage firm.Funds may have to offload 30 billion rupees ($364.9 million) to 40 billion rupees of the combined company's stock, said an executive with a large fund house."

HDFC Bank and HDFC are fairly liquid stocks and have a lot of demand. This will hold true for the combined entity, too," the executive said, adding that funds that need to sell will find buyers.This clause could curtail the ability of fund managers to take incremental exposure to the banking bell-weather, the chief executive of another large-sized mutual fund pointed out.“Selling to meet the regulatory requirements could be seen by some in the market as a desperate act and the fund managers would not get good buyers at the right price," the person said. "This will impact the fund's performance."

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