Complacency alert: The recent shortfall in deposits is a wake-up call for Indian banks

In the previous five instances, the deposit-credit growth alignment was a result of both a rise in deposit growth and a fall in credit growth. The current alignment is due to a fall in credit growth and no improvement in deposit growth.

This is worrisome. It may be a harbinger of more structural changes in the saving behaviour of households. If the banking system aspires to go back to the 14-16% deposit growth rate before 2016, it may have to treat depositors differently.

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A deposit crunch per se does not impact credit growth: The popular narrative that a deposit crunch prevents credit growth is inaccurate and not based on any fundamental understanding of banking economics. Current and saving accounts are the cheapest source of funding for banks.

Even retail fixed deposits work out cheaper than capital market-based borrowing by banks. Thus, a deposit crunch increases the cost of funds for banks. The hue-and-cry is, therefore, over the unavailability of cheap funds and worries about squeezed margins.

To explain, higher cost of funds are more easily passed on to retail borrowers without impacting the lender’s margin than they are to commercial borrowers. Banks that are unable to price commercial loans well see a fall in net interest income.

Thus, the cries from lenders with high exposure to commercial and large corporate borrowers. To debunk this narrative of deposit growth hurting credit growth, we only need to look at the 2004-2007 period. During this phase, credit growth was typically 8 to 10 percentage points above deposit growth.

Banking cannot rely on assumptions of sustained financial repression: Quite a few economies globally follow financial repression. Financial repression, among other things, also implies that savers get returns often below the inflation rate (i.e., their real interest rate is negative).

This is expected to boost economic activity by providing cheap credit to corporates and government. Even market-driven economies such as of the US resorted to financial repression after World War II, and more recently during covid, to boost the economy.

Interest rates on savings accounts were deregulated long back. However, the inertia of financial repression may still be continuing. Until recently, Indian savers did not have many options and had to make do with negative real interest rates on most of their bank savings.

But things are changing. Former Reserve Bank of India (RBI) governor Shaktikanta Das expressed several times his worries about deficiencies in banks’ deposit mobilization, given how depositors are increasingly turning to capital markets and other financial intermediaries.

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Between 2013 and 2023, household financial assets increased from 41% of gross domestic product (GDP) to 46%. Further, the annual asset allocation of deposits and currency has dropped from 67% of financial assets to 45% (Source: Banking for a Viksit Bharat, BCG Report).

This may be a structural shift in savers’ behaviour. Maturing capital markets and the digitization of the financial system are helping savers.

So, what can a bank do differently?: First, it must improve the way it typically measures the performance of business units (BU) and make it reflect economic reality. To explain, BUs are notionally charged for the funds they use by a mechanism called fund transfer pricing (FTP).

BU performance is measured by taking its interest and fee income and removing FTP, credit cost and operating expenses. The joker in the pack is FTP. If it is driven by the actual cost of funds, which in turn is impacted by economically unjustifiable cost of deposits, it ceases to represent the actual opportunity cost of the funds given to the BU.

Arguably, lending-oriented BUs get to show a higher margin, have less motivation to price loans better and still get rewarded. But deposit-raising BUs often get just the operating cost of raising deposits plus some minor incentive for deposit mobilization.

Only a few banks estimate the FTP by taking the opportunity cost of the funds, which is much higher than the incurred cost. Unless most banks follow a comparable approach, internal pressures from dominant lending BUs will prevent banks from shifting to a more reasonably priced deposits.

Of course, the actual cost of funds and the actual interest income impact overall profitability. But a more economically-balanced incentive structure for deposit-heavy BUs vis-à-vis the lending ones will address deposit mobilization issues.

Also read: Growth in bank deposits has been slow because RBI wants it to be slow

Second, analytics-driven decision-making is largely missing on the liability side. Analytics can play a role in the optimal pricing of deposits and prevent the attrition of loyal depositors. Depositors can earn 0.5-1.0% higher return by parking savings in debt mutual funds focused on bank debt.

If this trend strengthens, banks will see their cost of funds structurally move up. It makes more sense for banks to treat depositors as partners in business and offer a economically rewarding deal.

The author is a quantitative risk management professional and a visiting faculty of risk management at IIM Calcutta