Repricing liquidity

The Indian money market serves as the primary channel for short-term funding across banks, public financial institutions, non banking financial companies (NBFCs), Housing Finance Companies (HFCs) and large corporates. Certificates of Deposit (CDs), largely issued by banks, and Commercial Papers (CPs), issued by corporates and financial entities, form the backbone of this ecosystem. On the demand side, mutual funds constitute the dominant investor base in these instruments.

Recent developments suggest that the money market has entered a phase characterized by elevated CD issuance (Exhibit 1), structurally wider spreads, low CP issuances by corporates, alongside an ever-prevalent feature of low secondary liquidity

Exhibit 1:

Certificate of Deposits (CD) by Scheduled Commercial Banks issuances rise Source : RBI, SBIFM Research

However, unlike earlier episodes of stress, particularly the post-IL&FS period of 2018-19, current conditions do not appear to stem from credit deterioration. Instead, they reflect a complex interaction between structural investment preferences by retail investors, and regulatory requirement of Liquidity Coverage Ratio (LCR) by banks, seasonal Asset under management (AUM) patterns for mutual funds, and portfolio construction preferences within the mutual fund industry.

From mid-2023 onwards, banking system liquidity began normalizing after a prolonged period of surplus conditions (Exhibit 2). Banks, that had earlier relied comfortably on deposit growth, increasingly faced challenges in mobilizing incremental deposits at competitive rates. At the same time, credit offtake began to show signs of revival. Since 2022, barring a brief period of Oct-2024 to Oct 2025, bank credit had been healthy and has outpaced the deposit growth (Exhibit 3). Even now, bank credit has recovered sharply from the May’2025 lows of 9% to 14.5% by Jan 2026, with most banks revising their credit growth guidance for FY27 upward. This combination-deposit mobilization pressures alongside steady credit demand-pushed banks toward greater reliance on wholesale funding through CDs (Exhibit 4).

Exhibit 2:

Source : RBI, SBIFM Research; NB: Banking system liquidity refuse to net LAF surplus

Exhibit 3:

Bank credit growth has been outpacing deposit growth… Source : RBI, SBIFM Research

Exhibit 4:

...thereby pushing up the system system-wide credit-deposit ratio to elevated levels Source: RBI, SBIFM Research

Outstanding CD issued by scheduled commercial banks rose significantly, expanding from approximately Rs. 3 trillion at the start of 2023 to ~Rs. 6 trillion by end Jan 2026. Jan and Feb 2026 witnessed particularly strong issuance activity. This shift reflected banks’ emphasis on resource mobilization, especially in the context of quarter-end balance sheet considerations and improved loan growth momentum.

Alongside higher issuance volumes, spreads on CDs relative to 3-month Treasury Bills widened meaningfully (Exhibit 5). After an initial softening following policy rate cuts during 1H 2025, spreads began rising steadily from July’2025 onward, moving from roughly 30–40 basis points to 75-80bps by end 2025 and touched even 175bps by Feb’2026 over relevant T-bill. The current spread levels are even higher than those observed during the liquidity dislocation of 2018–19. However, unlike that period, the present widening does not reflect concerns over asset quality or counterparty risk; instead, it mirrors structural supply-demand imbalances and the funding needs of banks operating under tighter deposit conditions.

Exhibit 5:

3-month CD spreads have widened to ~175bps against T-bill by end January 2026 Source : Bloomberg, SBIFM Research

Exhibit 6:

Total CP outstanding is nearly INR 2 trillion lower than CDs outstanding Source: RBI, SBIFM Research

While CD supply surged (i.e. the short-term funding needs of banks surged), the Commercial Paper (CP) market is experiencing a noticeable moderation (Exhibit 6). Corporates that had previously accessed short-term markets, reduced or halted CP issuance. CP spreads are relatively more compressed. This is because anecdotal evidence suggests that bank working capital lines linked to external benchmark lending rates (often T-bills plus some spread) are cheaper than likely CP yields. Clearly, the latter is more cost-effective. To sum, corporate borrowing from money market is low due to more attractive rates being offered by banks.

The CP market consequently became concentrated in issuance by NBFCs, housing finance companies, and select public financial institutions. As corporate CP volumes diminished, the breadth of tradable names has narrowed significantly, further reducing market depth, especially beyond very short tenor.

On the demand side, mutual funds constitute the dominant investor base in the money market instruments.

While CD issuances are on the rise, the fund flows in the relevant mutual fund schemes, which can subscribe to money market papers, is limited. To give some backdrop, the Indian mutual fund framework imposes clear limits on duration and credit risk through SEBI’s category classification system. Each debt category has prescribed Macaulay duration limits and weighted average credit score requirements. Funds cannot freely migrate to riskier profiles without regulatory and documentation changes.

In practice, this structure enforces discipline but reduces flexibility during volatile periods. Liquid funds, for example, cannot invest beyond 91 days, while overnight funds are restricted to one-day instruments such as TREPS. Furthermore, equity and hybrid funds often maintain cash balances for margin requirements related to futures positions, and these balances cannot be freely deployed into longer-dated CP or CD instruments.

As a result, headline liquidity metrics-such as large volumes in the collateralized TREPS market—overstate the amount of AUM available for CD and CP deployment (Exhibit 7). Only a subset of debt funds has both the mandate and the risk appetite to meaningfully invest beyond overnight instruments.

Exhibit 7:

Average daily volumes in overnight segment Source : RBI, SBIFM Research

Changes in debt mutual fund taxation announced in Union budget 2023 and made effective April 2023 significantly altered the attractiveness of debt mutual funds for retail investors by aligning taxation with marginal income tax rates (Exhibit 8). Further in July 2024 budget, the indexation benefits enjoyed by debt mutual funds, held for over two years, were removed. This reduced the post-tax return advantage of any debt funds relative to bank fixed deposits.

Exhibit 8:

Taxation changes in debt mutual funds in India announced in Union budget 2023 Source Budget documents, SBIFM Research

Consequently, incremental flows into duration-oriented debt categories have been subdued. Instead, AUM growth has concentrated in overnight funds, which serve primarily as corporate cash management vehicles. Liquid fund and money market AUM has increased in line with nominal growth, while mid to longer-duration categories have experienced either stagnation or modest outflows

Also, incremental flows since April 2023 in pure debt funds is now predominantly institutional and corporate, with retail participation skewed toward hybrid and equity categories. This shift increases managed AUM volatility, as institutional capital is inherently more tactical and liquidity sensitive.

As banks’ struggle for both CASA (current and savings account) and sticky fixed deposit, deposit mobilization challenges has led banks to deploy both CD issuances and bulk deposits as a tool to raise funds. While Mutual funds subscribe to Bank CDs, they are a competing product to banks’ bulk deposits. Banks’ bulk deposits do not have daily MTM adjustments and offer competing returns to mutual funds, thereby turning out to be a more preferred investment avenue for some corporates in recent times. Thus, apart from taxation, the increased bulk deposits by banks are also driving reduced inflow into mutual fund schemes.

Despite large outstanding volumes of CDs and CPs, actual secondary market liquidity remains limited (Exhibit 9). Trading activity is concentrated in very short residual maturities, often within 30 days, and primarily in high-grade names. Insurance companies and provident funds are largely absent from this segment, while banks participate selectively, mainly for liquidity coverage ratio (LCR) management and largely restricted to AAA exposures within its residual maturity.

Exhibit 9:

Total Secondary Market Trade (reference period December 2025) Source :CCIL, RBI, SBIFM Research

As a result, mutual funds frequently are the only remaining secondary trading partners. However, given that redemption patterns are often synchronized across fund houses, selling pressure tends to emerge simultaneously across participants, reducing effective bid-side depth. This structural asymmetry constrains duration rebalancing and encourages conservative, diversified portfolio construction. Funds are compelled to avoid concentration risk and illiquid exposures. The illiquidity in CP markets is especially pronounced. Outside a small set of high-quality issuers, exit opportunities are limited, reinforcing a hold-to-maturity bias among investors. Furthermore, limited secondary market depth forces investors to demand additional spread compensation for liquidity risk.

Seasonality also plays a central role in shaping money market dynamics. Every March, (as also around other quarter end months) corporates withdraw significant sums from liquid and money market funds to manage their balance sheet and meet tax and reporting obligations. Banks also attract short-term deposits during this period. As much as 20–25% of liquid fund assets under management (AUM) may temporarily exit the system.

These funds typically return in April, generating strong reinvestment demand and causing short-term rates to decline. This predictable cycle influences portfolio construction. For instance, in January and February, mutual funds tend to avoid buying three-month papers to prevent amplifying exposure to post-March reinvestment risk.

Hence, there could be a mismatch between the tenor of paper issued and preferred, thereby also accentuating its impact on spreads. This recurring seasonal pattern amplifies short-term volatility in spreads and issuance preferences, even when underlying liquidity conditions remain broadly stable as was the case in this financial year.

While CD rates are operating at a significant spread to T-bills, there is a wide divergence in overnight rates. There has been a good 25-50bps spread between TREPS and interbank Call money rate- both key instruments in overnight segments (Exhibit 10).

Exhibit 10:

TREPS signal excess Tri-party liquidity, yet money markets remain unfunded Source: RBI, SBIFM Research

In developed markets such as the United States, money market funds have direct access to central bank reverse repo facilities, allowing overnight rates to align closely with policy corridors. In India, non-bank entities lack direct access to the Standing Deposit Facility (SDF), and the bulk of overnight activity occurs in collateralized segments such as TREPS. At times, this leads to meaningful divergence between policy rates and collateralized market rates. In current times, banks are borrowing in TREPS and lending in RBI’s SDF platform- thereby sometimes earning an arbitrage.

Broadening access to central bank liquidity facilities for non-banks could potentially enhance rate transmission and reduce volatility in collateralized segments. However, such reforms would need to be weighed against monetary policy transmission objectives and systemic risk considerations.

There could be some moderation in CD spreads in April after the March redemption cycle is over further the CD supply could also moderate. Banks’s guidance suggests that credit outlook stays healthy over the coming quarters. As such, banks would be in continued needs of funds. However, with current rise in CD rates, banks have seen a flattening of yield curve in the borrowing space. This may prompt them to gradually shift away from short-tenor CDs towards longer tenor infrastructure and tier II bonds also if their asset liability considerations permit.

Banks are generally restricted by regulation from issuing regular long tenor non-convertible debentures (NCDs) and can only issue infrastructure bonds if they have infra-eligible assets. In FY26, there was a hiatus where banks issued infrastructure bonds but lacked the corresponding infra-eligible assets, which seems to be resolved now, potentially allowing for increased supply. There is a demand from provident funds and other long-term investors for longer tenor papers. Hence, deploying such a strategy could also help cooling CD spreads.

The current phase of India’s money market is characterized not by credit fragility but by structural investment pattern changes emerging from post-covid period and frictional liquidity dynamics. The expansion of CD issuance reflects banking system funding realities, while the contraction of corporate CP issuance underscores the competitive dominance of banks in an intermediated system. On the other hand, mutual funds demand appetite has been constrained by lack of flows in the desired schemes (both due to taxation and better returns in competing bank products), regulatory portfolio constraints, secondary market illiquidity, and concentrated investor participation. Thus, elevated CD spreads are best understood as the equilibrium outcome of deposit constraints, credit growth, and limited non-MF participation.

Unless structural participation broadens or liquidity mechanisms evolve, the Indian money market is likely to continue exhibiting episodic mismatches between supply and demand. These mismatches will remain a defining feature of short-term rate behaviour, independent of underlying credit fundamentals.