Funds crunch: Banks and NBFCs rush to the money market

August 25, 2023
Posted by: OptimizeIAS Team
Category: DPN Topics

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Funds crunch: Banks and NBFCs rush to the money market

Subject: Economy

Section: Capital Market

Context: Banks raising short term finance due to liquidity crunch caused by the incremental CRR (I-CRR) norm.

Key Points:

Liquidity tightening in the banking system following the introduction of the incremental CRR (I-CRR) has prompted banks and NBFCs to raise short-term funds from money markets to manage their immediate fund requirements.
Apart from liquidity shortage in the banking system caused by ICRR and GST collections, robust credit growth is further making it necessary to secure short term funds.
Funds are being raised via certificates of deposit (CDs) and bulk deposits. CD rates have gone up by about 10-15 bps in the last fortnight. Banks will be paying much more than CD rates for high value bulk deposits.
The situation is expected to last till the end of September when government spending kicks in.

Certificate of Deposit (CD)

A Certificate of Deposit (CD) is a financial instrument issued by banks and financial institutions to raise funds from the public.
It’s a fixed-term deposit that offers a higher interest rate compared to regular savings accounts. CDs cannot be withdrawn before maturity without incurring a penalty.
They are tradable and can be sold in the secondary market before maturity. The minimum deposit amount and the tenure of CDs can vary among banks.
Certificate of Deposits (CDs) typically offer higher returns than savings deposits due to several factors:
- Fixed Term and Illiquidity: CDs have a fixed term or maturity period, during which the deposited amount remains locked. Since the funds are illiquid until the maturity date, banks can offer higher interest rates as they can use these funds for longer-term lending or investment activities.
- Lower Liquidity Risk: Since customers can’t easily withdraw funds from a CD before maturity without incurring penalties, banks have more certainty about the availability of funds for a longer period. This reduced liquidity risk allows banks to offer higher interest rates.
- Market Rates: Interest rates on CDs are more influenced by market conditions and the prevailing interest rate environment. When market interest rates are higher, banks may offer higher rates on CDs to attract funds.
- Investment Options: Banks often invest the funds obtained through CDs in longer-term assets, such as loans, mortgages, or bonds. These investments can potentially generate higher returns, which banks can then pass on to CD holders in the form of higher interest rates.