The RBI’s Overnight Triumph and India’s Term Market Problem

India’s monetary framework has evolved dramatically over the last decade. The Reserve Bank of India today operates a far more sophisticated liquidity management system than it once did. Overnight rates are largely aligned with the policy corridor, liquidity operations have become more market-oriented, and the transition towards modern benchmark-based monetary operations has broadly strengthened policy credibility. Yet beneath this operational progress lies an uncomfortable reality, which is, India’s term money markets remain fragmented, shallow and periodically unstable.

The result is a peculiar contradiction. The RBI increasingly succeeds in managing the overnight rate, but monetary transmission across the broader curve remains uneven.

This distinction matters because modern monetary policy is not merely about controlling overnight money. Economic activity depends on the pricing of term funding, the rates at which banks, NBFCs, corporates and financial intermediaries borrow beyond a single day. If those rates fail to move coherently with policy intent, transmission weakens even when the central bank appears operationally successful.

That is increasingly visible in India.

The overnight segment of the market is now relatively well-anchored. Instruments such as TREPS, the call money market and overnight liquidity facilities generally reflect the RBI’s stance with reasonable efficiency. Through variable rate repos, reverse repos, standing facilities and liquidity fine-tuning, the RBI has acquired significant influence over the shortest end of the curve.

The challenge begins further ahead.

India’s term money market spanning certificates of deposit, commercial paper, term repos and related funding instruments frequently behaves in ways that diverge from the overnight signal. Three-month or six-month funding costs may remain elevated even when overnight liquidity appears comfortable. NBFC borrowing spreads may widen while the policy corridor itself remains orderly. Corporate issuers may face volatile refinancing conditions despite expectations of monetary easing.

This divergence exposes the deeper structural limitations of India’s financial architecture.

In theory, the overnight indexed swap market should help bridge this gap. OIS contracts are designed to reflect expectations of future overnight interest rates and therefore future monetary policy. In developed markets, OIS curves often serve as the cleanest representation of policy expectations and the primary benchmark for hedging interest-rate risk.

In India, however, the relationship between OIS markets and actual funding conditions is often imperfect.

The reason is straightforward. OIS primarily prices expected overnight rates. But the real economy increasingly borrows through term instruments whose pricing depends not only on policy expectations, but also on liquidity preferences, collateral availability, sovereign borrowing pressures, institutional risk appetite and balance-sheet constraints.

As a result, Indian OIS markets sometimes price an easing cycle while actual term funding markets remain stressed.

One can observe periods where:

• overnight liquidity remains abundant,
• OIS curves rally in anticipation of future rate cuts,
• yet CD and CP spreads remain elevated,
• NBFC funding costs rise,
• and market participants continue hoarding liquidity.

This creates a disconnect between derivative pricing and real funding conditions.

The implications are significant because hedging becomes less efficient when the hedging instrument and the underlying funding exposure cease to move together. A bank or an NBFC borrowing through CP or term liabilities may hedge using OIS swaps. But if credit spreads or liquidity premia widen independently of policy expectations, the hedge only partially works. What remains is basis risk — the risk that policy-linked instruments and actual funding costs diverge materially.

To be fair, this is not entirely an Indian phenomenon. Even advanced financial systems experience episodic dislocations between swap markets and funding markets during periods of stress. But in India, the divergence tends to be more structural than temporary.

Several factors explain this.

First, India’s financial system remains heavily bank-dominated. Unlike mature market economies where deep institutional debt markets distribute risk broadly, India still relies significantly on banks and a relatively narrow investor base for term funding. This amplifies liquidity stress during periods of uncertainty. Even when the RBI eases liquidity and OIS markets begin pricing future rate cuts, banks may still face funding pressures from deposit competition, balance-sheet constraints or rising credit demand. As a result, actual term funding costs such as CD rates can rise even while policy-linked swap markets imply easing, exposing the disconnect between monetary expectations and real funding conditions.

Second, sovereign borrowing requirements are exceptionally large. Government bond supply often dominates the fixed-income landscape, influencing liquidity conditions and crowding bank balance sheets. Consequently, the term structure frequently reflects not only monetary policy expectations but also fiscal financing pressures.

Third, India’s non-bank financial sector remains vulnerable to confidence cycles. Episodes such as the IL&FS crisis demonstrated how quickly funding markets can fragment despite ample systemic liquidity. Mutual funds, NBFCs and corporate issuers can face severe refinancing pressure even when the RBI maintains accommodative overnight conditions.

Fourth, term market depth itself remains underdeveloped. Secondary market liquidity in CPs, CDs and corporate bonds is still limited compared with advanced economies. During stress, liquidity evaporates quickly and spreads widen sharply.

In other words, India structurally has multiple money markets that do not converge smoothly (See Table)

None of this implies that the RBI has failed. In fact, the central bank deserves considerable credit for modernising India’s monetary operating framework. Inflation targeting has improved policy credibility. Liquidity management has become more sophisticated. Payment systems and market infrastructure have evolved significantly. India’s financial markets today are far more resilient than they were a decade ago.

But the RBI’s success at the overnight end may also have concealed the unfinished work further along the curve.

Historically, Indian monetary policy evolved around managing banking system liquidity and ensuring orderly sovereign financing. That framework worked reasonably well in a bank-centric economy. But as markets deepen and non-bank intermediation grows, the importance of coherent term funding conditions rises sharply.

The next phase of monetary evolution therefore requires moving beyond overnight rate management towards deeper term market development.

That does not mean the RBI should directly target the entire yield curve. Nor should it suppress market pricing or eliminate risk differentiation. Markets must retain the ability to price credit and liquidity risk honestly.

However, the central bank can help improve transmission through several measures:

• strengthening term repo markets,
• broadening participation in money markets,
• improving secondary market liquidity,
• enhancing collateral frameworks,
• encouraging stable market-making,
• and communicating liquidity intentions more clearly beyond the overnight horizon.

Equally important is the need for continued fiscal discipline. As long as sovereign borrowing requirements dominate the financial system, clean separation between monetary policy and funding pressures will remain difficult.

India therefore stands at an important transition point. The country now possesses a reasonably modern monetary operating framework, but its term market ecosystem remains partially incomplete. Overnight rates are increasingly well-managed, yet term funding conditions still fluctuate under the weight of structural fragmentation, fiscal dominance and liquidity asymmetries.

The issue is not whether India’s money markets function. They do. The issue is whether they function coherently enough for monetary policy signals to travel smoothly across the curve.

That question will increasingly define the effectiveness of India’s financial system in the years ahead.