Structural imbalance hinders banks

The structural imbalance in the Indian banking system's funding dilutes the passing of benefits derived from the monetary policy changes to customers, according to India Ratings and Research.

In a research paper, it said "structural imbalances in the Indian banking system's funding structure are diluting monetary policy transmission, crowding out corporates from the money market and discouraging long-term savings in the economy".

Banks' growing dependence on short-term deposits to fund an increasing share of long-term infrastructure and residential mortgage loans has built refinancing pressures for them, making it difficult to bring down the cost of deposits.

As a result, banks have been slow to reduce their lending rates - base rates for the banking system have fallen by an average 40 bps (basis points) since April 2012, compared with the 125 bps reduction in repo rate by the Reserve Bank of India, says the paper.

The dilution in transmitting the monetary easing is a policy challenge as banks are the dominant source of funding to corporates and individuals.

According to India Ratings, dependence on certificates of deposits (CDs) has also grown steadily and the Indian banking system has converted from being a net lender in the money market till 2005 to being a net borrower.

The growth in CDs crowds out corporates, which see a drop in commercial paper (CP) volumes every time banks step up CD issuances.

The effect has been visible since FY11, and particularly in March 2013 high CD issuances by banks led to a fall in outstanding CP, thereby exposing the limited ability of the domestic money market to fully accommodate the shift in banks' liabilities to the short term.

Banks have been trying to reduce the structural imbalance by encouraging long-term deposits; however, their availability is limited to large banks.

A sustainable source of long-term liabilities is therefore needed to match the growth in long-term infrastructure and residential mortgage loans, but regulations do not permit banks to issue bonds without the backing of infrastructure loans.

It may therefore be timely to consider permitting banks to issue senior long-term debt within limits, India Ratings suggests.

A balanced asset liability position and low funding gaps will reduce the banking system's vulnerability to liquidity shocks, increase banks' flexibility in monetary transmission and help deepen the domestic bond market.