Dipping deposits

Even as the banking sector has been going through difficult times over the last few years due to huge NPAs, fraudulent practices and scams, now a new syndrome of decline in deposits has set in, this year, foreboding structural liquidity problems for the future. According to the RBI, by the end of first quarter of 2024, when credit grew at 17.4%, deposits grew at 11.1% year on year, pushing the credit-deposit ratio to the highest levels in the last two decades. The contribution of CASA (Current Account Savings Account) has decreased from 43% last year to 39% this fiscal year, as depositors were lured by stock markets, mutual funds, or other high-return investment avenues.

Evidently, depositors who once found bank schemes safe and profitable are now moving to capital markets and other financial intermediaries, including mutual funds, insurance funds, and pension funds. A lot of fintech firms and financial companies are offering attractive high-return products with lower tax rates, making bank deposits an unwise option for investors. In response, banks have launched equally lucrative products at competitive prices. The result is a natural decline in deposits, as a paradigm shift has occurred in the narrative of savings and investments. Lower tax rates, higher returns, and flexibility in exit have become key determinants for individual and household savings, which normally contribute to a lion’s share of bank deposits.

On the other hand, credit growing ahead of deposit growth means a heads up for the health of the banking sector as it implies negative effects such as credit crunch, liquidity crisis, higher costs of borrowing from other sources and, consequently, low profitability. Besides, declining deposits lead to decreased ability of banks to handle credit risks and also affect the financial stability of the institution. Private Sector Banks (PVBs) bear the brunt the most since they operate on higher LDR (loan-to-deposit ratio) vis-à-vis Public Sector Banks (PSBs). Some banks even began selling loan books to maintain liquidity.

The decline in deposits is not exclusive to banks in developing countries but is also observed in European monetary financial institutions. Data from S&P Global Market Intelligence and the European Central Bank shows that in France, Germany, Italy, and Benelux and Nordic countries, deposits fell by 3.9% year-on-year to 21.675 trillion euros by June 2023, with Spain experiencing the worst decline, at 9%. The failure of banks to pass on higher interest rates to depositors is seen as a major factor pushing them to shift money to higher-yielding products, in addition to other factors like rising interest rates, growing customer focus on pricing, and shifting funding compositions. However, the decline in deposits is more ominous for banks in developing economies, as they lack the financial stability of their developed counterparts.

The lack of innovation and poor product diversification in the Indian banking sector are said to be major reasons for the fall in deposits. To reverse this decline, economists suggest that banks focus more on mobilising small deposits and leverage their branch networks to create a wider deposit base. Unfortunately, banks show little enthusiasm for 'financial inclusion' unless it is mandated under government schemes. Even then, their involvement is often perfunctory. Moneylenders still control around 70% of credit in the informal sector, mostly in black.

Small and marginal farmers, petty businesses, food and refreshment shops, and family-run occupations still depend on local moneylenders, often referred to as ‘loan sharks,’ for loans up to Rs. one lakh, with interest rates ranging from 15% to 30%. Reaching out to these segments can help banks build a strong customer base with stable deposits. According to a study, poor people withdraw their earnings deposited by employers and use the cash in informal financial services to meet survival needs. Banks need to address the 'perceived benefit challenge' by bridging the gap between the intent and reality of financial literacy.

Thorsten Beck , (Professor of Financial Stability at European University Institute), Vasso Ioannidou, (Professor of Finance at Bayes Business School) et al. (https://cepr.org/) suggest twofold policy options, namely fine-tuning the existing regulation and supervision and impacting major structural changes. While the former focuses on liquidity checks, monitoring uninsured depositors, providing higher capital buffers for increasing bank resilience, risk-based pricing of deposit insurance etc., the later involves narrow banking (100% Reserve Requirement) or collateral backed deposit fundings, contingent measures such as automatic charges triggered by high outflows to discourage withdrawals, and extending the scope of deposit insurance to all deposits as a means to withstand unforeseen crises. But these options could be hard choice for banks in developing countries, especially ‘narrow banking’, for it defeats social good. Moreover, persistent problems like bureaucratisation and dearth of professionalism may stand in the way of reform. However, while in the long run banks can strive hard to revive their credibility through greater transparency and professionalism, in the short run three basic areas can be prioritised to address the decline in deposits: (i) amendments to liquidity requirements, (ii) enhancements to the supervision of liquidity and funding positions, and (iii) improving how funding fragilities are incorporated into the computation of Pillar 2 liquidity and capital guidance.

Part of the blame should also fall on financial markets, as they often lack self-regulation. Peter Lee, editorial director of S&P Global, raises the question of who should set the short-term price of money that underpins financial markets: central banks or private market leaders? In capitalist economies, the price is largely determined by market forces, whereas in welfare states like India, state interventions are indispensable. Effective control of money markets and better regulation of the capital market by the RBI and SEBI, respectively, within their jurisdictions under various laws, can help check the flight of deposits to risky alternative products. Though market corrections help regulate the flow of funds between deposits and investments, a dip in the equity market does not necessarily lead to growth in deposits; on the contrary, it may trigger a boom in gold markets, enticing depositors.

State interventions are necessary to maintain harmony between financial markets and banking institutions. Returns on investment (ROI) among various financial products need to be controlled through checks and balances to ensure equilibrium between deposits and other financial products. For instance, the increase in Securities Transaction Tax (STT) on futures from 0.0125% to 0.02% and on options from 0.0625% to 0.1% is an effective measure to control stock markets. Similarly, raising short-term capital gains tax from 15% to 20% and long-term capital gains tax from 10% to 12% are prudent steps. For example, why should an FD yield much lower returns when the same amount can pay three times more through PMS? Tax parity among financial instruments and proper pricing control deserve serious consideration.

The writer is a former Addl. Chief Secretary of Chhattisgarh. Views expressed are personal