Balancing Act: Addressing India's Growing Credit-Deposit Gap and Its Financial Implications - Vansh Aggarwal

 

Balancing Act: Addressing India's Growing Credit-Deposit Gap and Its Financial Implications

The growing disparity between credit and deposit growth in India's banking sector is indeed a significant issue with potential implications for liquidity, financial stability, and the broader economy. This divergence—where credit growth has outpaced deposit growth—can be traced to several interconnected economic, regulatory, and behavioural factors, and understanding them is key to addressing the potential risks posed by this trend. 

1. Money Creation Process and the Expected Correlation 

In theory, when a bank extends a loan, it simultaneously creates a deposit, since the borrower’s account is credited with the loan amount. This is how the banking system expands the money supply. However, the current situation in India reflects a break in this expected relationship, as the loan growth exceeds deposit growth. As of October 2024, bank loan growth in India stood at 12.8% year-over-year. This reflects a robust demand for credit across various sectors. 

Conversely, deposit growth has been lagging. In the fortnight ending October 4, 2024, deposits grew by 11.8% year-over-year, slightly below the loan growth rate. The disparity between loan and deposit growth has led to an elevated loan-to-deposit ratio. In December 2023, the LDR reached a two-decade high of 80%, indicating that banks are lending a larger proportion of their deposits. This mismatch hints at underlying factors that are impacting the banking sector's liquidity and deposit accumulation. 

To address the loan-deposit growth disparity, the Reserve Bank of India (RBI) increased the Cash Reserve Ratio (CRR) by 50 basis points to 4.5% in August 2024, aiming to tighten liquidity and encourage banks to raise deposit rates. 

2. Key Factors Contributing to the Credit-Deposit Gap 

- Increased Physical Cash Withdrawals: 

A surge in cash withdrawals has diminished the pool of deposits within the banking system. As cash is withdrawn, it no longer counts as part of the bank's deposit base, leading to a reduction in available funds even though credit continues to grow. The increase in currency circulation, noted by the Reserve Bank of India (RBI), has been a notable factor in this imbalance. 

- RBI's Forex Interventions: 

The RBI's foreign exchange market interventions play a crucial role in influencing liquidity. When the central bank sells foreign exchange reserves (dollars) to stabilise the rupee, it absorbs rupees from the banking system, effectively tightening liquidity. This policy has recently been employed to stabilise the rupee, contributing to a lower growth in deposits as rupees are removed from circulation. 

- Government Cash Balances: 

The Indian government holds substantial cash balances with the RBI, especially when it collects taxes or issues bonds but delays expenditures. These balances also reduce the liquidity available in the banking system, limiting deposit growth. Since these funds are temporarily out of circulation, banks lose access to potential deposits. 

 

- Regulatory Requirements (CRR and SLR): 

The Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) impose limits on how much of their deposits banks can lend. A certain proportion of deposits must be held in reserve or invested in government securities, which restricts the funds available for credit expansion. As loan demand surges, banks are increasingly constrained by these requirements, further compounding the credit-deposit gap. 

3. RBI's Quantitative Tightening 

In response to the inflationary pressures post-pandemic, the RBI has been gradually tightening liquidity to control the money supply. The RBI engaged in bond sales for eleven consecutive weeks up to September 20, 2024, marking the longest streak since January 2022. 

During this period, the RBI sold government bonds totaling ₹240.6 billion. These operations were conducted in small quantities to avoid market disruption, addressing demand-supply dynamics and supported by factors such as bond index inclusion flows and long-term investor interest. 

This reversal of the expansive policies during the COVID-19 recovery period has contributed to the liquidity crunch. While intended to keep inflation under control, this tightening policy has led to a reduction in available money in the banking system, amplifying the gap between credit and deposits. 

4. Impact of Changing Household Savings Behavior 

A shift in household savings patterns is another critical factor. With rising economic uncertainty and changing investment opportunities, individuals are choosing to allocate funds into other asset classes (e.g., real estate, equity markets, or mutual funds) rather than traditional bank deposits. 

Data from the Reserve Bank of India indicates that mutual funds attracted 6% of household savings in FY2023, a notable increase from previous years. This behavior change reduces the inflow of fresh deposits, despite the growing demand for loans, which exacerbates the disparity. 

In 2024, the RBI incentivized bank deposits by enhancing term deposit rates, with deposits yielding 6%+ reaching 86.6% of total term deposits. Additionally, the RBI proposed new guidelines to strengthen banks' liquidity, set to take effect in 2025, to address risks of rapid digital withdrawals. 

5. Consequences of the Credit-Deposit Gap 

- Liquidity Challenges for Banks: 

As loans outpace deposits, banks face increasing challenges in maintaining sufficient liquidity to fund their lending operations. This liquidity crunch forces banks to explore alternative funding options, such as borrowing from the market or issuing short-term debt instruments like certificates of deposit (CDs). However, these methods introduce interest rate risk and create volatility in funding sources, which could destabilize banks, particularly in a high-interest-rate environment. 

- Potential Increase in Deposit Rates: 

To attract more deposits, banks may raise interest rates on savings and fixed deposits. While this could help bridge the credit-deposit gap, higher deposit rates would increase the cost of funds for banks, squeezing their profit margins. This could discourage banks from lending aggressively, which in turn might slow down credit expansion and, by extension, economic growth. 

- Economic Implications: 

A sustained credit-deposit gap could lead to tighter credit conditions, affecting both corporate investment and consumer spending. If banks are forced to curtail lending, it could dampen economic activity, especially in sectors reliant on bank financing, such as real estate, infrastructure, and small businesses. 

6. Long-Term Financial Stability Risks 

If the gap between credit and deposit growth persists, it could raise concerns about the long-term stability of India’s banking system. Banks may become increasingly reliant on short-term borrowings, which are more susceptible to market fluctuations and interest rate changes. In extreme cases, this could lead to liquidity crises or bank failures if institutions are unable to roll over their short-term debts. 

Conclusion 

The growing disparity between credit and deposit growth in India's banking sector highlights a complex interaction of economic forces, regulatory constraints, and behavioural shifts. While credit expansion supports economic growth, the accompanying shortfall in deposit accumulation presents risks that could challenge the long-term liquidity and stability of the financial system. 

The situation may require proactive measures by the RBI and policymakers to ensure a more balanced and sustainable banking environment. This could involve further fine-tuning of liquidity management, deposit mobilisation efforts, or adjustments in regulatory frameworks to reduce pressure on banks and maintain the financial system's resilience.