Some analysts contend that the deposit problem is entirely imaginary, but slow retail deposit growth and shifts in savings trends reveal valid concerns for banks’ lending capacity
The Reserve Bank of India (RBI) governor has urged banks to increase deposit growth. The governorтАЩs exhortations have been met with criticism and even ridicule from some commentators.
Some analysts contend that the deposit problem is entirely imaginary and that banks do not face any deposit constraint in the matter of making loans. They are wrong. The RBI governorтАЩs concerns are well-founded, as a hard look at the criticsтАЩ propositions will make clear.
i. Savers, especially young savers, are turning to alternatives to deposits such as mutual fund and insurance products. That should not worry banks because what is parked with mutual funds and insurance companies returns to the banking system as deposits.
It is true that money invested in mutual funds and insurance products must come back to the banking system. However, when savers invest in banks, they choose saving or fixed deposits with relatively long maturity. The amounts they invest in mutual funds and insurance companies return to the banking system as current account deposits or fixed deposits of very short maturity. The latter are less stable than saving deposits. As a result, banks are constrained in the loans they can finance with current account or short-term fixed deposits. More on the importance of the type of deposit later.
ii. Loans create deposits, not vice versa. So the idea that deposits can constrain loan growth is plain wrong.
That loans create deposits is one of the more famous propositions of Modern Monetary Theory (MMT). Its meaning must not be misconstrued.
A bank can make a loan through an entry in the ledger. The bank then makes a matching entry for deposits on the liability side of its balance sheet. So, yes, the bank can conjure up loans and deposits out of thin air. However, when the borrower issues a cheque against the loan in order to make a payment, the deposit will need to be backed by funds. For its immediate needs, the bank can borrow funds from the central bank or in the inter-bank market.
There are limits, regulatory and prudential, to such borrowings. To safeguard its stability, the bank will have to go to the ultimate savers and garner deposits, instead of accessing funds from intermediaries. Again, how loans are funded is material.
iii. Deposit growth is linked to the creation of money by the central bank. It is no use blaming banks for the slow growth of deposits if the central bank is not creating enough money in the first place.
Money supply is equal to base money (bank reserves plus currency) times the money multiplier. If the central bank wishes to increase the money supply, it can buy bonds from banks through open market operations (OMO), so that bank reserves rise.
Money supply is also equal to currency plus deposits. When the money supply goes up, deposits on the other side of the equation rise correspondingly. Combining the two equations above, if deposits are not rising fast enough, it is contended, is because the central bank is not creating enough money.
There are two fallacies in this line of argument. First, central banks cannot be doing OMO and increasing bank reserves just to increase deposits тАФ OMO is done to meet the interest rate target at any point in time.
Second, we need to be clear about how exactly an increase in reserves contributes to an increase in deposits. When banks have excess reserves, loans can grow faster than otherwise. Incremental loans will be matched by entries of incremental deposits in banksтАЩ balance sheets. So, yes, we will see deposits rise as money supply expands.
However, if liquidity and interest rate risks are to be properly managed, incremental deposit entries will have to be backed by stable funds in the form of deposits. So much for the criticisms of the RBI governorтАЩs remarks.
Now to the point about the importance of the type of deposit a bank sources for funding loans. Deposits can happen through current accounts, saving accounts, and fixed (or term) deposits (FDs).
Current accounts carry zero interest and hence are free from interest rate risk. However, as mentioned earlier, current account deposits pose high liquidity risks for banks. Saving deposits, unlike current accounts, carry an interest cost. The interest rate on saving deposits is supposed to be considerably lower than on FDs and it fluctuates in a narrow range, so the interest rate risk is also low. If saving deposits are retail in nature, they are considered highly stable, that is, they pose low liquidity risk.
FDs carry a higher interest rate than both current and savings deposits, but retail FDs are relatively stable compared to corporate FDs (which are typically of shorter maturity). From the point of view of managing liquidity risk, deposits below Rs 2 crore are considered a preferable form of retail deposits, followed by those below Rs 5 crore. The exhortations to banks to grow deposits, it must be understood, are about growing retail deposits as distinct from large value wholesale deposits.
That is turning out to be a challenge for many banks. Banks lulled themselves into thinking that they could access retail deposits at a lower cost through online banking and under-invested in their branch networks. They have since woken up to the centrality of the branch network when it comes to accessing deposits. Public sector banks have the legacy of a large network of branches. But they need to rejig their branches, given the rise of new deposit growth centres in the country.
Many private banks offer interest rates close to those of FDs on all saving deposits above a certain minimum. This is a travesty of the concept of saving deposits. Saving deposits are supposed to offer a low interest rate as banks provide a payment service against them. Because depositors are okay with a low interest rate, saving deposits will not flee with interest rate changes.
These features cease to apply if depositors are offered FD-like interest rates on saving deposits. The RBI must mandate that only deposits with an interest rate of up to, say, 150 basis points above the State Bank of IndiaтАЩs saving deposit rate can be categorised as a тАЬsavingтАЭ deposit.
Banks have also shot themselves in the foot by over-selling mutual fund and insurance products in order to boost fee income. Little did they realise that this would exact a cost in terms of excessive dependence on bulk deposits to drive loan growth.
Banks need to remind themselves that loans also bring valuable fee income. They must think through the role of fee-based products such as mutual funds and insurance in the overall scheme of things. The mantra for banking stability remains unchanged: A bankтАЩs focus must be on the core business of getting retail deposits and making loans.
ttrammohan28@gmail.com
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