India's financial market regulator and its central bank are widening an investigation into how merchant banks manage retail subscriptions in public debt issues, two sources with direct knowledge of the matter told Reuters.

The Securities and Exchange Board of India (SEBI) barred JM Financial from taking new mandates this week, saying it had found that funds from connected entities were used to inflate subscriptions and provide an assured exit to investors.

JM Financial said in a stock exchange filing on Thursday that it will fully cooperate with SEBI in its investigations.

The Reserve Bank of India (RBI), meanwhile, has told JM Financial's non-banking unit to stop any form of financing against shares and debentures, including loans to customers to subscribe to initial public offerings (IPOs).

Several other cases are under investigation to see if merchant banks provided investors with an exit through connected non-banking finance firms, said the two sources, who declined to be named as they are not authorised to speak to the media.

Investigators are also studying if disproportionate loans were given to subscribes and whether customer identification processes were not adequately followed, the sources added.

SEBI and RBI did not respond to requests for comment.

Indian regulations do not bar investors from taking on credit to subscribe to debt securities in public issues.

However, assuring investors of a profitable exit would break the code of conduct for merchant banks which bars them from creating an artificial market.

MARKET IMPACT

Indian companies have raised more than 200 billion rupees ($2.4 billion) via public issues of bonds so far this financial year, more than double last year, data from Prime Database showed. This is also the highest in last five years.

Five merchant bankers told Reuters that the regulatory scrutiny of processes followed in the public debt market could cut subscriptions for such issues and raise the cost of funds.

"This will now lead to a slowdown in retail subscriptions, as an artificial demand for the product was created, which actually did not exist," said one banker, declining to be identified as they are not authorised to speak to the media.

Non-bank lenders, which are looking to diversify their source of funds after the central bank raised capital requirements for banks to lend to them, may be hardest hit.

Bank lending to NBFCs has slowed in the past few months and SEBI's investigation could push them back to fundraising through private debt placements, said Vinay Pai, head of fixed income at Equirus. ($1 = 82.7070 Indian rupees)

(Reporting by Jayshree P Upadhyay and Dharamraj Dhutia; Additional reporting by Bhakti Tambe; Editing by Ira Dugal and Alexander Smith)