How to bridge the wide gap between banks' credit and deposit growth?

To address the issue of deposit growth trailing lending growth, which can have potential systemic risks, some banks are also adopting innovative strategies to attract deposits

Both Union Finance Minister Nirmala Sitharaman and Reserve Bank of India (RBI) Governor Shaktikanta Das recently expressed concern over the wide gap between credit and deposit growth in the banking system. In fact, Mr Das has been categorically pointing out this anomaly in his public appearances. For instance, in the statement announcing the monetary policy decision last week, he noted that alternative investment avenues seemed to be becoming more attractive for retail customers, resulting in challenges for banks on the funding front. Consequently, banks depend on short-term non-retail funds and other instruments to meet the incremental credit growth demand. This can expose the banking system to structural liquidity issues. Deposit growth has been trailing lending growth for some time, with potential systemic cause and effect. On their part, as reported by this newspaper on Wednesday, some banks are adopting innovative strategies to attract deposits.

It remains to be seen how such measures would work in bridging the gap. In the last financial year, for instance, while credit expanded at about 20 per cent, deposit growth lagged at about 14 per cent. The gap was also highlighted in the RBI’s latest Financial Stability Report. This trend is reflected in the credit-deposit ratio, which has increased since September 2021. It peaked at 78.8 per cent in December 2023 before moderating to 76.8 per cent at the end of March 2024. The ratio is particularly high among private-sector banks. Although there have been instances of divergence lasting about 2-4 years, both the finance minister and the RBI governor have done well to highlight the issue and nudge banks to take corrective action.
 

While there is no immediate risk to the banking system, the reasons for divergence and what could be done before it becomes a bigger problem are worth debating. With the recovery in the economy after the pandemic, the increase in credit growth, which is higher than the nominal gross domestic product (GDP) growth, is understandable. However, there could be a variety of reasons responsible for lower deposit growth. Households might have shifted to other avenues as the RBI kept a negative real policy rate for a while to support the economy. The better performance of the Indian stock market in recent years could also have attracted household savings. Another reason could be the decline in incremental net financial savings in the household sector. The latest available data showed that it fell to a multi-decade low of 5.3 per cent of GDP in 2022-23.
 

While the recovery in household financial savings remains critical for the economy at large, banks can do more to attract additional savings. The net interest margin of scheduled commercial banks at the end of March was 3.6 per cent. Given the competition for funds, banks would have to sacrifice a bit on the margin front to attract deposits and keep their balance sheets more stable. Private banks are usually in a better position to do this because of higher interest margins. However, a bigger and long-term issue is that of a sustained high general government Budget deficit. To keep the borrowing costs down, banks are expected to keep a part of deposits in liquid assets or mainly government bonds. Progressively reducing this requirement will allow interest rates to align with the demand and supply of savings and encourage household savings. Since this process requires large economic adjustments, it may not happen anytime soon. For now, banks will need to adjust to lower margins and offer higher deposit rates.