16 August 2024 : Indian Express Editorial Analysis

1. A FINANCING CHALLENGE

(Source: Indian Express; Section: The Editorial Page; Page: 08)

Topic: GS3– Indian Economy

Context:

The article discusses the severe deposit crunch faced by Indian banks, where the growth of bank deposits is lagging behind credit growth, leading to significant challenges.

The Current Deposit Crunch: An Overview

• The Indian banking sector is experiencing its most severe deposit crunch in two decades, characterized by a widening gap between bank deposits and credit growth.
• The primary source of funding for banks, current and savings accounts (CASA), which once formed 43% of total deposits, has now decreased to 41%.
• Although this reduction may seem minor, it has significant implications for the banking industry. Core deposits are crucial for banks as they provide a stable funding source and shield them from fluctuations in market rates.
• As the share of core deposits shrinks, banks face increased pressure on profits and heightened exposure to interest rate risks, especially in an environment of persistent high policy rates and rising credit costs.

Impact on Economic Activity and Lending

• The decline in deposit growth extends beyond the banking sector, potentially affecting the broader economy. As banks face increased liquidity risks, their capacity and willingness to fund loan growth could diminish.
• This, in turn, could make it more challenging for borrowers to secure funds or could increase their cost of borrowing, particularly at a time when banks are becoming more cautious about credit risk.
• For borrowers with limited alternatives to bank financing, this situation could hinder profitable investments and dampen economic activity, leading to broader economic repercussions.

Disruptive Forces and Competitive Pressures

• The foundational structure of the banking sector is being reshaped by several disruptive forces, including rising competition, technological advances, and deregulation.
• For decades, household savers in India tolerated negative real returns on their bank deposits, with inflation averaging 6.6% and savings bank deposits yielding only 3-5%.
• However, the situation has changed as savers now seek superior returns from other asset classes, which could result in a structural shift away from bank deposits.
• This shift raises several concerns that need to be addressed, particularly regarding the impact on loan growth and the overall health of the banking sector.

Challenges for Smaller Banks and Lending Constraints

• The deposit crunch is not confined to smaller banks; even the largest public and private sector banks are facing funding pressures.
• Smaller banks, however, are more vulnerable as they rely heavily on core deposits and have fewer alternatives for funding.
• These banks are likely to hold more liquid assets to meet unexpected surges in demand, which could limit their ability to allocate funds to loans.
• This constraint could further limit last-mile lending, particularly through non-banking financial companies (NBFCs), microfinance institutions, and other smaller players who primarily depend on banks for funding. A slowdown in deposit growth could, therefore, hinder consumption and investment activities, potentially impacting economic growth.

Sectoral Impact and Future Outlook

• Not all sectors are equally affected by the slowdown in deposit growth. While retail demand for funds remains robust, the industrial sector has yet to experience significant pressure due to healthy profitability and strong debt-to-equity ratios.
• However, if and when industrial demand for funds extends beyond working capital needs, the deposit crunch could pose a significant challenge to economic activity.
• The situation could change if equity markets cool off or if the government introduces tax breaks on bank interest, making bank deposits more attractive.
• Regardless, banks will need to innovate by offering more competitive savings alternatives and managing costs effectively.
• This scenario underscores the need for policymakers to focus on deepening bond markets to provide additional avenues for funding and investment.

How Can the Indian Banking Sector be Fortified Moving Ahead?

Building Big Banks:  The Narasimham Committee Report (1991) underscored the importance of India having three or four prominent commercial banks with a presence both domestically and internationally, in addition to foreign banks. The second tier could include numerous mid-sized banks, including niche institutions, with a widespread presence across the economy.  Consistent with these suggestions, the government has already consolidated certain PSBs and taken measures to establish entities like a Development Finance Institution (DFI) and a Bad Bank.  Requirement for Differentiated Banks:   While the universal banking approach has been commonly favoured, there is a demand for distinct banking entities to address the unique needs of diverse customers and borrowers.  Essentially, these specialised banks would facilitate financial access in specific areas such as retail, agriculture, and MSMEs.   Additionally, establishing proposed DFIs or niche banks as specialised entities would provide them with access to low-cost public deposits and enable improved asset-liability management. Blockchain Banking:   Enhanced risk management can be achieved, and neo-banks have the opportunity to harness this technology for advancing digital financial inclusion and supporting the increased growth of an aspiring and emerging India.  In the realm of Indian banking, the implementation of technologies such as Blockchain holds the potential to facilitate prudential supervision, making oversight and control over banks more streamlined.  Addressing Moral Hazard:   Until now, the occurrence of public sector banks failing has been infrequent, primarily due to the concealed sovereign guarantee, instilling greater trust in the public. Nevertheless, the ongoing privatisation of PSBs challenges this assurance.   Consequently, the upcoming wave of banking reforms should emphasise the necessity for increased individual deposit insurance and efficient orderly resolution mechanisms. This aims to reduce moral hazard and systemic risks, minimising the financial burden on the public treasury.  ESG Integration:   It could be beneficial for Distinctive Banks to consider listing on a reputable stock exchange and embracing the ESG (Environmental, Social Responsibility, and Governance) framework.  This approach aims to enhance value for stakeholders over the long term.  Enhancing Banking Institutions:   To address vulnerabilities, the government should refine regulatory measures, enabling banks to develop diversified loan portfolios, instituting regulators for specific sectors, and granting increased authority to handle deliberate defaults effectively.  Facilitating Corporate Bond Market Growth:  In order to establish a responsive banking system in a dynamic real economy, there is a requirement to promote the growth of the corporate bond market, thereby transitioning away from a bank-centric economic model. Enhancing Risk Management Models:  Develop and implement internal risk models tailored to individual States, similar to the Bank Exposure Risk Index, to assess potential risks associated with lending to State government entities and infrastructure projects.  Addressing Changes in Liabilities:  Recognize the changing nature of liabilities influenced by digitisation and evolving consumption trends. Develop strategies to adapt to shifts in retail deposits, especially in Tier 1 and 2 centres.

PYQ: With reference to the Banks Board Bureau (BBB), which of the following statements are correct? (2022)  The Governor of RBI is the Chairman of BBB. BBB recommends for the selection of heads for Public Sector Banks. BBB helps the Public Sector Banks in developing strategies and capital raising plans.   Select the correct answer using the code given below:  (a) 1 and 2 only    (b) 2 and 3 only  (c) 1 and 3 only    (d) 1, 2 and 3  Ans: B

Practice Question:  Discuss the impact of the current deposit crunch on the Indian banking sector. How might this situation affect broader economic activity, and what steps should policymakers consider to address these challenges? (250 words/15 m)