Whenever our friends Jinny and Johnny come back late from their office, they order pizza for dinner. Today is one such day. After having ordered pizza on phone, they are waiting eagerly for the delivery boy to ring the doorbell. Jinny is getting restless. But Johnny knows how to engage a restless soul in meaningful discussion. Let’s see how he starts the discussion today:
Johnny: I recently heard someone say that all markets are in some
way interconnected. How could this be possible? For instance, what could be the link between the call money market and the fish market? Do you have any idea?
JAYACHANDRAN / MINT
Jinny: Well, the common link between the two is fairly obvious. Both the call money market and the fish market are affected by liquidity. However, one is affected by the liquidity in the market (money supply) and the other is affected by the liquidity in our ponds and lakes (water supply). But jokes apart, I think you want to know about the call money market, right? Hmm! Nice way of starting a discussion. But, before I jump to the call money market, it would be better to give you an idea about the money market in general. The money market is a market where transactions relating to short-term borrowing and lending of money take place. These short-term transactions are generally done by buying and selling debt instruments maturing within a year. So, you can also say that the money market deals with short-term financial assets that are close substitutes of money.
The money market has different segments. The call money market is one of its segments. This market deals with overnight borrowing and lending among the banks. If the borrowing and lending is for more than one day but extending up to 14 days, the same is called the notice money market. Interestingly, call or notice money markets have no physical presence. So, they cannot have an address like your fish market. Orders in the call money market can be placed just like orders for pizzas over the phone.
Johnny: Sounds interesting, but I was just wondering why banks have to borrow from the call money market when the whole day they are busy taking money from their depositors.
Jinny: Well, the need to borrow money from the call money market arises due to short-term mismatches of funds. As a part of their operations, banks borrow money from their depositors and lend money to their borrowers. In this process, banks’ assets and liabilities get locked into different maturities brackets. Some deposits are repayable instantly on demand. However, the banks cannot instantly take the money back from their borrowers. Banks keep some cash ready for meeting any demand from their depositors but sometimes, the demand could be higher than the cash in hand. Further, banks may also urgently require funds for meeting their statutory requirements of cash reserve ratio and statutory liquidity ratio.
During the course of the day, after taking care of all their needs, some banks may have surplus cash in hand and some may have a deficit. The bank having a deficit will call up the bank having a surplus to borrow money overnight or for any period extending up to 14 days. The borrowing bank has to pay interest on the borrowed money. You might have observed that call money interest rates undergo changes on a day-to-day basis. That’s because of changes in demand and supply.
Johnny: So, the call money market really helps banks in managing short-term deficit or surplus of money. But tell me, why has the central bank prescribed prudential limits?
Jinny: Well yes, the central bank has prescribed prudential limits for banks on borrowing and lending in the call money market. Lending of scheduled commercial banks, on a fortnightly average basis, should not exceed 25% of their capital fund.
However, banks are allowed to lend a maximum of 50% of their capital fund on any single day, during a fortnight. Similarly, borrowings by scheduled commercial banks should not exceed 100% of their capital fund or 2% of aggregate deposits, whichever is higher. However, banks are allowed to borrow a maximum of 125% of their capital fund on any day, during a fortnight. Transactions in the call money market are not secured by any collateral. Prudential limits on borrowing and lending have been prescribed to ensure that the risk of default remains within the limit.
Johnny: But tell me, why can banks not borrow the money from other non-banking financial institutions such as insurance companies?
Jinny: Earlier, non-banking financial institutions were allowed to lend in the money market but now, except for primary dealers, all other non-bank participants have been phased out. The simple logic behind a pure inter-bank call money market is that it allows the central bank more flexibility in managing liquidity and short-term interest rates in the banking system. In case you have any more questions in mind, save them for some other time, because the pizza man has rung the doorbell!
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at email@example.com
What: The call money market deals with overnight borrowing and lending. Notice money market deals with borrowing and lending repayable within a fortnight.
Who: Banks and primary dealers participate in the call money market.
Why: The call money market helps banks to manage short-term deficit or surplus of money.
How: Transactions in the call money market can be executed over the phone or by any other means of communication.