Growing Deposit-Saving Gap in the Banking Sector

Growing Deposit-Saving Gap in the Banking Sector

Context:

Recently, the financial services sector experienced outflows of Rs 23,000 crore by foreign portfolio investors (FPIs), as per National Securities Depository Ltd (NSDL) data, due to lower deposit rates in the Indian banking system. 

• In response, Finance Minister Nirmala Sitharaman urged public-sector banks to intensify efforts to mobilise deposits through special drives.

About Widening Deposit – Credit gap:

• Credit and Deposit Growth Rates

• • As of mid-2024, credit growth was approximately 13.7%, while deposit growth lagged at around 10.6%. This disparity resulted in a credit-deposit (CD) ratio of about 80%.
    • Such disparity will affect credit distribution in the future, thus hindering economies of scale.

• Recent Deposit and Advance Trends

• • For the fortnight ending August 9, 2024, bank deposits increased by 11% year-on-year, whereas advances grew by 14%, highlighting the growing gap between credit and deposit growth.

• Decline in Low-Cost Deposits

• • The Reserve Bank of India (RBI) reported a decline in low-cost current and savings accounts (CASA) from 43% of total deposits a year ago to 39% in the current financial year.

Reasons for Widening Deposit- credit Gap:

• Higher Credit Growth: Credit growth is outpacing deposit growth, with credit growing around 20% compared to deposits at 11%, driven by strong loan demand in retail and services sectors.
• Shift in Household Savings: Households, especially younger investors, are increasingly choosing higher-yield investments like mutual funds and real estate over traditional bank deposits, reducing deposit mobilisation.
• Interest Rate Dynamics: Despite the Reserve Bank of India raising policy rates, banks have been slow to increase deposit rates, making deposits less appealing and leading banks to rely on short-term, more volatile funding sources.
• Regulatory and Structural Factors: Regulatory requirements like Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) limit banks’ lending capacity, pushing them towards alternative funding sources that may increase liquidity risks.
• Economic Conditions and Market Sentiment: Fluctuating economic conditions, including inflation and market volatility, challenge banks in attracting deposits, as alternative investments may seem more attractive during such periods.
• Reliance on Short-Term Non-Retail Deposits e.g. Corporate Deposit,Interbank Deposits etc. :Banks are increasingly turning to short-term non-retail deposits and other liability instruments to meet rising credit demand.

Impact of Widening Deposit- credit Gap:

• Liquidity Risks and Structural Shifts in Banking:
  The banking system’s reliance on short-term non-retail loans and a shift in household savings towards higher-yielding investments pose liquidity risks and affect deposit growth.
• Increased Funding Costs:
  To attract deposits, banks might offer higher interest rates, raising their funding costs and potentially compressing net interest margins, which can negatively impact profitability.
• Demographic Skew and Decline in Bank Deposits:
  The high concentration of term deposits among senior citizens and a decrease in the share of bank deposits in household savings highlight changing deposit patterns.
• RBI’s Warning and FPIs’ Sell-Off:
  The RBI warns of financial stability risks due to a widening credit-deposit gap, while FPIs’ significant sell-off in August reflects concerns over bank health.
• According to Economic survey 2019-20 Reliance on Short-Term non-retail  Funding from corporates can lead to :
  • Increased Funding Costs: Competition for short-term deposits, like certificates of deposit, may lead banks to offer higher rates, compressing net interest margins and affecting profitability.
  • Liquidity Risks: Short-term deposits are volatile and can be withdrawn quickly, posing liquidity risks and potential instability in economic stress periods.
  • Sensitivity to Interest Rate Movements: Shifting from low-cost deposits to short-term funds increases sensitivity to interest rate fluctuations, potentially impacting lending rates and slowing credit growth.
  • Impact on Asset Quality: Reliance on costlier funding may pressure banks to lend to riskier borrowers, increasing non-performing assets (NPAs) and risking financial stability.
• Potential for Higher Loan Defaults:
  Rapid credit expansion without adequate deposit backing may lead to higher loan defaults and deterioration of asset quality, as banks might lend to riskier borrowers.
• Impact on Economic Growth:
  Liquidity constraints and increased funding costs could lead to more cautious lending practices, potentially slowing credit growth and dampening economic growth.

Way Forward to lessen Widening Deposit- credit Gap:

• Sanjay Agarwal from CareEdge Ratings noted that maintaining a credit-deposit (CD) ratio below 80% is essential to mitigate risks associated with high credit growth.
• Strategic Shift from Debt Funds to Bank Deposits: Encouraging a transition from debt mutual funds to bank deposits could significantly boost deposit growth.
• Proposed Measures to Encourage the Shift:
  • Tax Incentives for Fixed Deposits: Offering tax benefits to make FDs more attractive.
  • Marketing Campaign: Launching a campaign akin to “bank deposits sahi hai” to promote FDs.
  • Addressing Misaligned Incentives: Rectifying the incentives that lead bankers to prioritise insurance sales over FD renewals.
  • Banks must balance higher deposit rates with profitability concerns.
• Public-Sector Banks and Deposit Mobilisation Strategies:
  Public-sector banks should enhance their strategies by increasing deposit rates and introducing appealing schemes to attract savers.
• Reliance on term and time  deposits like saving account deposits , Fixed deposits that came in “trickles” but were the “bread and butter” of the banking system.
• Enhancing FD Competitiveness Through Taxation Reform
  • The primary difference between fixed deposits (FDs) and debt funds lies in taxation: FDs are taxed annually on interest income, while debt funds are taxed on redemption. 
    • To make FDs more competitive, a proposal suggests introducing a special class of FDs where interest income is taxed only upon withdrawal. This would enable higher income compounding for savers and potentially increase tax revenue for the government at redemption.
    • Consider avoiding TDS deductions before maturity to improve tax efficiency for investors.