Conundrum of the credit-deposit ratio: Understanding RBI's concerns

The Reserve Bank of India (RBI) has been repeatedly raising alarm about the widening gap between non-food credit growth and deposit growth in the banking sector, which raised the credit-deposit (CD) ratio to 78.1 per cent (80.3 per cent, including the impact of the merger of HDFC with HDFC Bank) in the last week of March 2024 – the highest since 2005. Even after five months, the CD ratio is still quite high at 77.5 per cent (79.5 per cent, including the impact of the twin HDFC merger).

To understand the RBI’s concern, one needs to understand the relevance of the CD ratio. The CD ratio is an important health indicator of a bank as it shows the bank’s ability to cover loan losses and withdrawals by its customers. A high CD ratio indicates that a bank has made a large amount of loans compared to its deposits. This is taken as a sign of increased risk and reduced liquidity. Too high of a CD ratio indicates a bank may have difficulty meeting its obligations.

The RBI is also concerned that the banks have turned to bulk deposits and certificates of deposit to mobilise funds, as retail deposits (both savings and term deposits) have become stagnant. This, according to the RBI, has a high potential to create ‘instability’ in their liabilities.

In this context, the following facts need to be noted:

1.      As government borrowings had shot up during the pandemic and credit growth had slackened, many banks witnessed a sizeable increase in their stock of statutory liquidity ratio (SLR) securities. As the economy started recovering, instead of raising deposit interest rates (and taking a hit to the net interest margin), many banks preferred to liquidate their excess SLR securities to finance credit demand.

2.      Another reason for the sluggish deposit growth is the huge cash balance maintained by both the central and state governments with the RBI due to the election season. This caused a bit of a short-term liquidity problem. After the government started spending, the liquidity also started improving. According to some media reports in August, banks have urged the finance ministry that government cash balances be held by them, rather than the RBI, to help improve liquidity. Under a new Cash Management Framework, SNA-SPARSH, introduced in 2021, government cash balances were directed to the RBI rather than to commercial banks.

3.      While loans create deposits, past data indicates that the pace of deposit mobilisation is relatively higher when incremental bank lending is dominated by corporate (wholesale) lending than retail lending (excluding home loans). As the current phase is marked by higher growth of retail lending (especially as reflected in credit card outstanding, unsecured personal loans, etc.), perhaps the pace of deposit mobilisation has been relatively slower.

4.      Many banks have started tapping the infrastructure bond market to address asset-liability management (ALM) concerns. It is advantageous for banks because it is exempt from regulatory reserve requirements such as the statutory liquidity ratio (SLR) and cash reserve ratio (CRR). Moreover, spreads are attractive for such instruments, and there is a lot of appetite among long-term investors. Hence, instead of the CD ratio, there is a need to look at the Credit to ‘Deposits + Borrowings’ ratio.

5.      There is a concern that the household sector’s savings are going to the capital market. While this may not affect systemic-level liquidity, it will certainly impact a few banks’ liquidity, as they will not be able to raise adequate deposits to fund their loan growth. But it has a positive side as it will help develop the corporate bond market, and some portion of credit risk will shift from the banking industry to the bond market, which is a long-pending demand.

In short, an optimum level of CD ratio has to be linked to the macro environment (drivers of credit demand), policy environment (incentives to raise funds from the bond market), fiscal arrangements, and the changing direction of financial regulation. In recent years, regulators have focused on more sophisticated measures of liquidity, such as the liquidity coverage ratio and the amount of high-quality liquid assets a bank holds, both of which probably provide a more accurate picture of a bank’s ability to weather a liquidity shock.

The author is a research economist and a former chief economist in the BFSI sector

Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper