The erstwhile ‘captive’ household (HH) savers who for decades put up with negative real returns have now tasted blood.
A rising and persistent gap between bank deposits and credit growth has led to the worst deposit crunch in two decades. The current and savings accounts (CASA) are banks’ bread-and-butter sources of funding. These are typically very low cost and currently account for 41 per cent of total deposits as against 43 per cent last year. Many would say that this is not that alarming. So why is everyone worried?
Core deposits provide a stable source of funding to banks, shielding them from fluctuations in market rates. As the core deposit share funds a smaller portion of their assets, banks face increasing pressure on profits. And if at the same time, the maturities of bank assets increase, it raises banks’ exposure to interest rate risks. In an environment of “higher for longer’’ policy rates and a potential rise in credit costs, there can be additional pressure on the profits and liquidity of the banking industry.
The negative effects of declining deposit growth can extend beyond the banking sector and spill over into the broader economy. As banks’ liquidity risk increases, their ability or willingness to fund loan growth can decrease. As a result, at a time when banks are becoming more sensitive to credit risk and tightening underwriting standards and loan terms, deposit erosion can further impair the ability of some borrowers to obtain funds or can increase their cost of funding. As some borrowers have few alternatives to bank financing, constraints on banks’ ability to fund profitable investments can adversely affect economic activity.
Multiple disruptive forces are reshaping the foundational construct of the banking sector. Rising competition, technological advances and deregulation over the years have significantly upped the competitive pressures facing banks. The erstwhile “captive’’ household (HH) savers who for decades put up with negative real returns have now tasted blood. In the last 30 years, inflation averaged about 6.6 per cent in India even as savings bank deposits fetched 3-5 per cent, yielding negative returns when adjusted for inflation. Yet, savers faithfully parked almost half of their financial savings into bank deposits enabling high-interest margins (as high as 4-4.5 per cent for certain banks). But savers are now getting far superior returns from almost every other asset class. The trend could become structural and throw up several issues that need to be examined.
First, what will be the impact of declining deposits on loan growth? This is a chicken-and-egg question: Do banks seek new deposits because of strong underlying loan growth? Or, do they seek opportunities to lend profitably because their deposit base goes up? Empirical evidence suggests that both are true.
Second, how widespread is the decline in deposit growth? All banks are facing funding pressures including the biggest public and private sector banks as evidenced by their management commentaries and financial results.
Third, is the erosion in deposits greater for smaller intermediaries? Since smaller entities have fewer alternatives to deposits, they typically fund a greater fraction of their assets through core and other deposits and rely less on external funds and other liabilities. The greater a bank’s reliance on deposits, the more it will have to hold liquid assets to meet unexpected surges in demand for funds by depositors. Hence, it will not be surprising if smaller players also tend to allocate a smaller fraction of their assets to loans than large banks.
Fourth, will last-mile lending be constrained as a result of the decline in deposit growth? The deposit crunch could impact eventual credit flow via NBFCs, microfinance institutions and other smaller players as they primarily depend on the banks for funds. Such constraints could hurt consumption and investment activities.
Lastly, are all loan portfolios affected to the same degree by slower deposit growth? So far, the demand for funds is not yet broad-based. Retail demand has remained robust, and industry hasn’t yet felt the need to join the fray in a big way due to comfortable profitability and healthy debt-to-equity ratios. However, if and when demand from industry moves beyond working capital or short-term needs, the deposit crunch could hurt potential economic activity.
Things could change — equity markets could cool off and relative returns may turn benign for banks or the government could chip in with tax breaks on interest from banks. However, what will not change is that banks’ ability to generate income and manage costs will be tested in newer ways. Banks need to provide more competitive alternatives to savers and also manage costs. This is one more reason for policymakers to double down on deepening the bond markets.
The writer is group chief economist, L&T. Views are personal
