Demonetisation in November 2016 was a challenge for many businesses, especially the small and medium enterprises (SMEs). It was, however, a boon for banks that saw a large growth in their deposits. Cash stashed away by households found its way into bank accounts. From 2015 onwards, industrial credit slowed down very sharply to hit a several decades low of around 5 percent in 2017, and after a blip up in 2018, continued slowing down.
This trend of deposit growth being higher than credit growth goes back to the financial year 2015. Deposits growth remained at double digit throughout this period. With deposit growth at double digit, and credit growth between 5 and 7 percent, banks were floating on easy liquidity.
As the COVID-19 pandemic hit in 2020, the Reserve Bank of India (RBI) unleashed additional liquidity and policy rate cuts that saw them hit all-time lows. For bank managers, the real challenge in the last five years was finding credit growth, and managing the impact of the pandemic on credit quality and on the organisation. For almost eight years, growing deposits was not a challenge.
This easy period of deposits for banks is coming to an end, and in the next couple of quarters we are likely to see the beginning of an intense competition for deposits. The RBI is on a clear and aggressive path of rate hikes and liquidity squeezing. The May and June policy rate hikes by the RBI’s MPC will be followed by similar hikes in August and September. Higher rates will ultimately be transmitted by banks on both sides of the balance sheet — in the pricing of loans, and deposits.
In the past, increasing policy rates were beneficial for banks as the transmission was asymmetric — quicker and larger for loans than that for deposits. In this cycle, it is likely to be different, and we may see sharper pricing up for deposits than loans. This relatively larger and quicker rate transmission on the deposit side will be driven by four factors.
First, credit growth will remain strong. While consumer credit will slow down due to higher interest rates, the demand for working capital from business will remain strong. Rising commodity prices are driving working capital demand as the cost of inventory has gone up. There are some early signs of capex revival which may further drive credit demand. After nearly five years, we are seeing credit growth in double digits. The policy of withdrawal of liquidity along with high credit growth will mean that the demand for deposits will increase.
Second, households are facing serious inflation that will dent savings. In addition to cost-of-living increases, households will see increase in the costs of borrowing. Over the last seven years as the industrial credit growth stagnated, banks and non-banking finance companies (NBFCs) have lent freely to households, and these consumer loans now form a larger share of the banks’ loan book than industrial credit. This expansion of consumer credit has been primarily in the top two income deciles of households which also are the biggest contributors to household savings.
From 2019, regulations have mandated the interest rate on all the consumer loans to be linked to external benchmark such as the repo rate or T-bill yields. These loans will, therefore, be priced sharply upwards. In case of longer maturity loans such as home loans, lenders will try to keep the monthly payments constant by extending the maturity of the loans. However other loans that constitute nearly 50 percent of consumer borrowing, such as personal (unsecured loans), vehicle loans, etc. will all see increase monthly repayments. The net effect of these rate hikes will be that households that contribute most to the banking deposit base will see their net savings (savings after loan repayments) shrink significantly.
Third, as the rate cycle peaks around October/November, debt mutual funds will become a very attractive alternative to investors. The yields on five-year AA corporate bonds have already started inching closer to 10 percent, and with the forthcoming policy rate hikes these yields will further go up. High-quality corporate bonds funds comprising AAA and AA rated papers, could start delivering double-digit yields as the rate cycle peaks. This would entice high network individuals (HNIs) and institutional depositors to move their money from deposits to these funds. Bear in mind that funds, held over three years, provide a sizeable tax advantage over deposits.
Finally, the COVID-19 pandemic has seen a very rapid increase in the adaption of digital tools — mobile apps especially – to conduct banking transactions. Thanks to these tools, opening new accounts and moving money between them is way easier now than was the case even three years ago. These tools, thus, make deposits much more fungible than before. It is much easier to woe a depositor by offering a higher rate than was the case just a few years ago. Digital technologies have also made it much easier now to move money from deposits to mutual funds.
The net effect of these factors is that the deposit market is now much more contestable. It is also important to note that over the last five years, several new players – the small finance banks and payment banks – have entered as competitors for deposits. Even the handful of deposit-taking NBFCs that have not focused much on raising retail deposits in an era where wholesale funding from banks and bond markets was very aplenty and cheap, would become active and aggressive in raising deposits.
Intensifying competition for deposits will mean that the cost of deposits will go up, and it will dent margins, unless the cost hike is passed on to the borrowers. Given the nascence of credit growth, it seems unlikely that there will be full pass through of deposit rate increases to loans. Bank margins will come down.
After a long time, bankers will realise that theirs in a unique business that must compete on both sides of the balance sheet. They will have to get ready to face something they haven’t for a very long time: intense competition for deposits.
Harsh Vardhan, a Mumbai-based management consultant, serves as an independent director on the board of Karur Vysya Bank. Views are personal, and do not represent the stand of this publication.
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