How faster deposit growth could become counterproductive for banks

Should deposit growth continue to outpace credit growth, banks may end up ceding some hard-earned 25-50 bps improvement in profitability or net interest margin gained in the past two years

Bank deposits have been growing in single digits of late. But ever since the economy opened up after the lockdown, there has been a peculiar trend, thanks to extreme risk aversion in the banking system. 

Deposit growth has started outpacing bank credit. The recent data for September indicates that bank credit grew 5.3 per cent, while deposit growth rate more than doubled to 12 per cent year-on-year. 

Should this trend persist, banks may be looking at ceding some hard-earned 25-50-basis points (bps) improvement in profitability or net interest margin (NIM) gained in the past two years. Simply put, faster deposit growth could well turn counter-productive for banks.

Interest rate transmission gathering momentum in the past year wouldn’t help even if deposit rates fall to a decadal low. If inflow of deposits increases further, banks may not have the requisite bandwidth to tweak rates.

Analysts at ICICI Securities say the flexibility to further reduce deposit rates will be low at negative real interest rate and unattractive to other investment options, such as small savings schemes and equities. 

“The repricing benefit will not be enough, given the spread between outstanding and fresh deposit rates is just 50 bps,” say analysts. 

The recent guidelines — which limit the current account pool that would likely be available to banks — could also lead to excess liquidity for public sector banks, while taking away one of the easiest low-cost options for private banks.

It is true that the bulge in deposits in India is not very different from global trends. A report by S&P Global dated October 1 shows that deposit growth in both low-income and upper-income segments outpaced the industry average in the US, indicating that household trust in deposits may have increased after the pandemic. 

Since deposits are the cheapest source of funds, this will be welcomed by banks. However, in India, it is coming at a time when loans are still getting repriced to benchmark rates. So far, the repo rate has been slashed 225 bps, whereas interest-rate transmission of 140–155 bps has taken place, indicating yield on loans may reduce further. To sum up, analysts at ICICI Securities say a shrinkage in NIM is imminent. “We revise our NIM estimates down by 5–15 bps for the banking universe, leading to a 3–7-per cent reduction in the operating profit and earnings,” they note.

The solution to this issue lies in the deployment of excess credit. How successful banks are with their festive loan melas will determine the trajectory of their profitability.