Should banks 'raise more deposits'? 

Representative image.

Indian banking loans are now growing more than banking deposits. As of July 15, 2022, bank credit grew by over INR 15 lakh crores over the past year, while bank deposits grew by less than INR 13 lakh crores.

The same time a year ago, in contrast, bank credit then had grown by just INR 7 lakh crores, much less than the near INR 16 lakh crore growth in bank deposits.

Does this portend an issue that banks should look to address now? To understand this better, let us consider how the overall banking system funds itself.

Deposit creation – linkage to loans 

A key route to banking deposit (and money) creation is the very act of giving fresh banking loans.

When a bank gives out a loan by crediting the borrower’s account (including with another bank), fresh deposits are created in the system. While individual banks might worry about raising deposits before making out loans, at a system level, every loan asset is self-funded by the deposit that it creates.

This is also true of bank lending to the government (e.g., banks buying GOI bonds in an auction) that fund government expenditure. Here, funds are routed via the RBI as the banker to banks and the government, and deposits are created only when the government spends the money.

While funding is not a constraint to lending at a system level, does the need for statutory reserves (SLR and CRR), or the need for banking capital, provide some guardrails on credit growth?

Note that bank lending to the government (in the form of GOI bonds) qualify as Statutory Liquidity Ratio (SLR) assets. Further, banks can convert excess SLR bonds into funds with the RBI via repos, which go towards their meeting statutory Cash Reserve Ratio (CRR) requirements.

If the government is borrowing (and therefore additional SLR asset creation is readily possible) and if RBI repo windows are available, meeting higher SLR and CRR requirements on fresh deposits is not a binding constraint on the system. The traditional textbook notion of central banks directly controlling money creation via a reserve ‘money-multiplier’ is now strongly challenged (see here).

Capital requirements on banking loans and monetary policy, however, do influence the supply and demand for credit.

Deposits and currency in circulation 

When depositors withdraw currency notes, banking deposits decline, as do banking funds with RBI (that qualify towards CRR requirements).

If the decline in bank balances with RBI results in a CRR shortfall, banks would have to repo their excess SLR balances with RBI to make up the balance. As argued earlier, creation of fresh SLR assets isn’t a constraint on the system today.

Deposits and foreign exchange flows 

Foreign exchange inflows create INR deposits. For example, if a company were to raise Foreign Direct Investment (FDI), their bank would credit the INR proceeds into their account. Against this the bank would register an increase in its own foreign currency assets held with overseas banks. If the RBI were to purchase this foreign currency in the spot market, commercial banking foreign exchange assets would reduce to that extent, while banking INR funds with RBI would concomitantly rise.

Across both legs, i.e., foreign exchange inflows alongside the RBI mopping them up, bank deposits would rise, matched by a like increase in banking INR balances with the RBI.

Conversely, foreign exchange outflows supplied by the RBI in spot markets would result in a drop in banking deposits and a concomitant drop in banking INR balances with RBI. If banking funds with the RBI dropped below CRR requirements, banks would need to repo their excess SLR balances to cover the shortfall.

Overall Deposit Growth 

Putting all this together, incremental banking deposit growth is the sum of the net increase in bank credit, the incremental banking funding of government expenditure, incremental foreign currency inflows, less the increase in currency in circulation.

This admittedly ignores some items (such as banking profits and revaluation of assets) but captures the essence of deposit creation.

For the year ending July 16, 2021, while banking commercial credit grew only by INR 7 lakh crores, there was significant bank funding of government expenditure, and a sharp net inflow of foreign currency. With all this, despite nearly INR 3 lakh crores increase in currency in circulation, total deposits grew by INR 16 lakh crores. All this also accounted for the sharp increase in banking funds with the RBI during the period as surplus banking liquidity.

In contrast, for the year ended July 2022, there was significant foreign exchange outflow, with the RBI having to net sell around USD 50 billion in currency markets. As a result, deposit growth ended lower than credit growth, and there was a concomitant drop in banking balances with the RBI. Note that this has hardly caused any overall funding issue, with surplus banking liquidity of INR 2.5 lakh crores still in the system.

Even if banking balances with RBI were to eventually drop below CRR requirements, given ample surplus SLR balances (and the ability to add to them), overall funding will hardly be an issue. Of course, interest rates would rise significantly if banking liquidity were to turn into a systemic deficit.

Summary 

Individual banks can try to manage their balance sheet growth appropriately. However, at a system level, items such as net foreign exchange inflows and changes to currency in circulation are largely outside of banking control. In turn, the system has little control on total deposit growth (in relation to credit growth) and on banking balances with RBI. Given this, exhorting the system to somehow “raise deposits” or increase funds with the RBI makes little sense. In fact, the RBI has far more control over the quantum of banking liquidity than banks do.

Finally, deposit growth trailing credit growth is not indicative of any fatal funding issue. Besides a possible increase in interest rates, it only implies a drawdown in banking funds with RBI, to be met by surplus reserve assets.

(Ananth Narayan is a banking and financial markets expert. He is currently Associate Professor at SP Jain Institute of Management and Research.)

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