Here’s how to bypass the hurdle of credit-deposit growth mismatch

One potential solution lies in regulatory intervention: allowing banks to issue bonds within a limited timeframe as a one-time measure to bolster their resources. To assess this proposal, it is crucial to first understand the current regulations governing bank bond issuance.

At present, banks can issue two main types of bonds: capital bonds and special bonds, which include infrastructure and green bonds. Capital bonds, encompassing additional Tier 1 and Tier 2 bonds, are issued to raise regulatory capital and are subordinate to deposits, meaning they are paid out after depositors in the event of liquidation. Infrastructure and green bonds are designated for specific purposes, with proceeds restricted to lending to designated borrower classes. Capital bonds are included in the net demand and time liabilities (NDTL) of banks for reserve requirement calculations, whereas infrastructure bonds are excluded. Beyond these categories, banks are not permitted to issue other types of bonds.

The proposed regulatory adjustment would introduce a temporary window, perhaps for a year, allowing banks to issue bonds solely for funding purposes to augment their liabilities. This initiative could attract long-term resources, addressing the issue of over 80 percent of bank deposits having maturities of less than one year.

With conditions attached

To mitigate potential risks, certain restrictions could be imposed on these bonds, such as:

* Only unsecured bonds rated above a minimum threshold (e.g., AA) would be eligible.

* Bonds must have a minimum maturity of three to five years, with no put or call options.

* The total issuance size would be capped at a percentage of the previous year's closing NDTL, for example, no more than 3 percent.

* Bonds would rank pari passu with deposits, i.e., their claim will have the same seniority as deposits in the event of liquidation of the bank.

* These bonds would have to be mandatorily listed to ensure secondary market liquidity.

These bonds would serve as a temporary funding mechanism to alleviate the current deposit crunch and secure long-term, stable funding for bank balance sheets. For practical purposes, these bonds should be excluded from NDTL calculations for reserve requirements, as their long-term nature would not strain bank liquidity. They could be included in NDTL calculations only in their final year of maturity, when they could be seen as exerting short-term liability pressures.

Bonds are not bulk deposits

It may be argued that these bonds resemble bulk deposits, which regulators discourage banks from raising. However, there are crucial differences between bulk deposits and bonds. Bonds are not redeemable before maturity, whereas a bulk deposit can be 'broken' before maturity at a small cost for the depositor, thus creating liquidity pressure on banks.

Additionally, bonds, being securities, can have a secondary market that bulk deposits cannot.

It is also important to highlight the distinction between these bonds and certificates of deposit (CDs) that banks issue. These bonds are long-term maturity instruments, whereas CDs are essentially short-term. Furthermore, bonds are securities that can be listed and have a secondary market, while CDs are not securities, making it difficult to create a secondary market for them.

Indian banks have experienced significant credit growth in the post-pandemic years, but weak deposit growth threatens to undermine this progress. Permitting banks to issue bonds could address the challenge of sluggish deposit growth and introduce a new asset class for long-term capital pools, such as those of insurance and pension funds. This strategy could prove beneficial for all stakeholders involved.

(Author thanks Chandan Sinha and Vinay Baijal for very valuable discussions.)

Views are personal and do not represent the stand of this publication.