View | Time to look at all the costs loaded on banks

Veteran banker Uday Kotak, in a recent post on X (formerly Twitter), pointed out that the slowdown in the growth of retail deposits poses a serious challenge to the business model of Indian banks. This article argues that banks have historically been the primary funders of India’s growth and regulators and lawmakers have imposed some justifiable costs on them. However, the question we need to ask is whether, given the structural shifts in saving and investing patterns away from bank fixed deposits (FDs) towards capital markets, it is time to debate some of the costs imposed on banks.

Let us begin with Mr Kotak’s concern: “If deposit tightness persists, it is a challenge to the banking business model,” he says, explaining that leading banks are paying 8% or more for wholesale deposits, and after factoring in cash reserve ratio (CRR), statutory liquidity ratio (SLR) and insurance costs, banks make no money at all on products like home loans.

Almost everyone is blaming the Reserve Bank of India’s (RBI) liquidity tightness for the high deposit costs and the RBI has been responding by injecting significant liquidity in the first quarter of this year—over ₹

7 trillion through forex swaps, repos, and bond purchases via open market operations (OMOs).

Yet, no bank has been able to reduce deposit rates, despite the RBI cutting the repo rate in February and likely to do so again on April 9. The frustration of Kotak and other bankers is that many bank loans are mandatorily linked to external benchmarks like repo (EBLR loans) and have been reduced when the repo rate is cut, but they are unable to reduce their deposit rates, seemingly due to liquidity tightness.

However, liquidity tightness does not fully explain banks’ inability to raise stable deposits. The larger reason for their failure to cut deposit rates is that retail investors are no longer primarily saving through bank FDs but are preferring mutual funds, as they offer better returns and are taxed less.

RBI Deputy Governor Rajeshwar Rao, in a speech delivered in January this year titled “Challenges in Liability Management: Maintaining the Balance,” detailed the amount of money being diverted from bank FDs to mutual funds.

SHARE OF THE STOCK OF FINANCIAL ASSETS OF HOUSEHOLDS

Source: RBI, Speech by DG Rajeshwar Rao at Mint BFSI Summit on 17 January

Even when an investor saves via mutual funds rather than banks, the money remains in the banking system. However, the maturity and reliability of that money change. Rao points out that the contribution of term deposits has declined from 65.8% of total deposits to 60.9%, while the share of savings deposits has increased from 25.3% to 29.2% and the share of current account deposits has risen from 8.9% to 9.9%.

This trend may have contributed to the improvement in net interest margins (NIMs) of banks from FY20 to FY22, but it turned out to be a short-term positive. Mutual funds continuously withdraw from their accounts for daily share purchases and sales, making it difficult for banks to lend long-term loans based on these CASA deposits. This leads to asset-liability mismatches.

As a result, many banks are forced to offer higher rates to attract one-year bulk deposits from corporates at 8% or more, or borrow via CDs (certificates of deposit) at similar rates, which in turn compresses their margins. CD issuances reached an all-time high of ₹10.6 lakh crore during FY25 (up to March 7), a 34% YoY increase, according to Care Ratings. Consequently, most banks have been reporting lower margins in FY25 with each passing quarter.

From a regulatory point of view, Rao worries in his speech that “higher reliance on short-term liabilities like CDs can have significant repercussions if market conditions deteriorate.” That is, if banks lend long-term loans (e.g., 3-5 year loans) on the strength of one-year CDs, they may face difficulties if they cannot roll over their CDs due to adverse market conditions.

In November 2023, the RBI explicitly warned banks that their credit-deposit ratios were reaching dangerous levels of over 80%. (To explain the regulator’s worry: for every ₹100 of deposits, a bank must keep ₹4 as CRR and ₹20 as SLR or government bonds, leaving ₹76 to lend as credit. A credit-deposit ratio over 76% can signal that banks are borrowing in the short-term market and lending long-term loans, which concerns the RBI.)

Since retail investors are unlikely to revert to bank FDs as their preferred mode of saving, policymakers, bankers, regulators, and the Indian economy in general may have to reconcile to the following points:

• Banks may remain the largest funders of India’s growth, but their contribution may gradually lessen. In other words, bank credit growth may not hit the 15-20% mark. Credit growth may eventually align more closely with nominal GDP growth, around 10-11%. However, with more savings being channelled through mutual funds, capital markets may fund the corporate sector more via CPs (commercial papers) and corporate bonds.
• Stock market investors in banks may also have to reconcile to lower loan growth and reduced margins in the medium term. The best performance of banks may already be behind us.
• To be sure, there will be differentiation among banks. Those with solid deposit franchises, such as salary accounts from large companies, may still be able to produce robust margins and decent loan growth. However, this may be possible only for the top few banks. Companies seldom shift their salary accounts, so younger banks will have to compete vigorously for salary accounts from emerging companies, MSMEs, and start-ups.
• Policymakers in government may need to recognise that the large difference in capital gains tax between debt and equity makes bank deposits inherently uncompetitive compared to equity mutual funds. This is not to argue for a change in capital gains tax but merely to point out that the significantly higher capital gains tax on debt instruments is making debt capital expensive in India.
• The government is also managing its money more effectively of late, leaving very little public float with banks. While this may reduce the fiscal deficit somewhat, it also means that banks are less able to provide loans, as their stable funds are depleting. (For a detailed analysis, see “New Funding Mechanism For Centrally Sponsored Schemes Hits Bank Deposits” here.)
• The RBI has a couple of points to consider:

a) The RBI has linked banks’ lending rates to external benchmarks like the repo rate, but it hasn’t linked bank deposits to the repo rate. As a result, in a rate-cutting cycle, banks’ product pricing (yield on loans) falls, but their raw material cost (cost of deposits) takes a while to fall and may not fall much at all due to the factors discussed. The RBI linked bank loans to external benchmarks to ensure better transmission of rate hikes and cuts.

To be a better monetary authority, the RBI is making banks pay a price in the form of lower margins. Again, this is not to argue that lending rates should be delinked from external benchmarks. (The need to link lending rates to external benchmarks arose because banks cartelised and didn’t pass on rate cuts.) However, a debate and review may be warranted on whether external benchmarks should apply only to loans and not to deposits.

b) The RBI’s flagging of high credit-deposit (C-D) ratios may seem overly cautious to some bankers. Banks have other sources of funds, such as refinancing by SIDBI and Nabard or funds raised through infrastructure bonds, which do not form part of deposits but contribute to credit or loans. Hence, a C-D ratio of 80% need not always signal dangerous over-lending by banks.

c) The RBI also goes to great lengths to protect consumers. Recently, it banned banks from penalising pre-payment of loans, not only by retail customers but also by MSMEs. This may be unfair to banks, as MSMEs can change their banks by rate shopping, leaving banks at a disadvantage. Here, the RBI is performing its role as the guardian of small borrowers at the expense of banking sector profits. There may be a two-sided debate on this issue as well.

All told, the entire ecosystem needs to acknowledge that the pressures on the banking system come at a cost. Perhaps some of these costs can be debated.