OPINION | When stock markets grow, do bank deposits shrink? New evidence says it depends 

The research provides an explanation of the relationship between financial markets and the banking system

Household savings have long been the backbone for credit creation and economic growth. These household savings are channeled through various financial institutions such as banks, financial markets, and insurance companies. Among them, banks and financial markets offer households alternative avenues to save and invest, differing in liquidity, interest rates, yields, safety, and accessibility.

This raises a fundamental question: does growth of one type of financial institution always come at the cost of another?

Answers from analysing data

Analysing data from over 4800 banks from 122 countries, we challenged the common perception that the financial markets and banks necessarily compete for households’ savings. On the contrary, it has been found that the relationship between banks and financial markets depends upon various factors such as income level, the structure of the financial system, and institutional strength. These findings move us beyond the old idea of constant competition and shows that, with the right policies banks and markets can grow together. 

Conventional wisdom on banks and financial markets

Historically, we have had a perception that the financial markets are a substitute for the banking system. Banks use households’ savings for credit creation whereas financial markets use households’ savings to provide funding to new age entrepreneurs through mutual funds, bonds, and stocks.

As financial markets grow, they provide higher yields to households, leading to funds shifting from bank deposits to other financial markets, especially in developing economies.

Recent trends make collection of stable deposits more challenging

The global financial market trends have changed dramatically, particularly after global financial crisis and Basel reforms. Over the last two decades the financial markets have grown substantially, but at the same time, due to Basel-III reforms, banks are encouraged to attract stable deposits, which becomes more difficult when financial markets are offering higher yields. Attracting stable deposits is made more challenging due to the digitalisation of financial markets and the banking system.

There is ample research available on how financial development leads to economic growth and lending, but limited research on how it affects the liability side of banks’ balance sheets, particularly for deposits. The gap is critical not only due to the importance of deposits for the banking system but also for credit creation and economic growth.

Categorising deposits

We fill this gap by examining the effects of financial market development on bank deposits in a cross-country study. We not only explored the relationship between financial market development and overall bank deposits but also examined the effects according to the characteristics of deposits such as transaction deposits and fixed deposits.

The bifurcation of deposits is important mainly due to their distinguished characteristics viz. transaction deposits are liquid in nature and provide liquidity to households, whereas time deposits behave like an investment product that are rate sensitive.

We further examine this relationship in various economic, regulatory, and financial system architectures, making this study comprehensive for wider audiences such as regulators, academicians, banks, financial markets, and public.

Key findings: 

1) Financial markets do not always compete with the banking system for deposits 

Contrary to popular belief, the study suggests that as financial markets expand, total and transaction deposits grow, suggesting that deeper markets raise overall savings rate and confidence, benefiting the banks.

2) Long term deposits face competition 

This relationship turns competitive for long term deposits. Longer term deposits see a decline when financial markets grow. The intuition is that as financial markets expand, they offer higher yields, causing households to reallocate their funds from lower yielding long-term deposit products to higher yielding financial products.

3) Development matters 

The most important insights lie in the cross-country differences

* In financially developed economies, banks and financial markets complement each other. Strong regulations, deposit insurance, and more robust supervision allow banks to attract more deposits even as financial markets grow.

* In less-financially developed economies, this relationship turns competitive. Market expansion comes at the expense of bank deposits, making the banking system less stable.

In a nutshell, financial markets are neither a friend nor a foe for banking system, it depends upon the institutional environment of the country.  

Conclusion

The research provides an explanation of the relationship between financial markets and the banking system, which is useful not only for the regulators and bankers, but also for policymakers, especially in emerging economies like India, where banks are currently struggling to attract households’ deposits.

The study suggests that to attract the household deposits, institutional settings need to be strengthened. A recent policy move, increasing deposit insurance from Rs 2 lakh to Rs 5 lakh is a perfect example of strengthening this environment. This measure boosts public trusts in banks, helping them retain deposits even as financial markets expand.

Second, policymakers must also recognize the deposit composition matters. As financial markets grow, attracting long-term deposits will be difficult. Therefore, rather than focusing only on long-term deposits, they should provide incentives and form guidelines and strategies to attract more transaction deposits which are stable in nature and important to comply to Basel-III norms.

Third, the study also highlights the importance of deposit insurance, effective supervision, and competition policy. These institutional settings determine the relationship between financial markets and banks. Absence of a strong institutional environment may destabilise the financial system.

Finally, the study highlights the importance of continuous and overall development of financial system rather than focusing on one institution over others. Developing financial markets without strengthening the banking system may make the banking system fragile, building both together promotes financial stability and growth.

(Nikhil Srivastava is from Birla Institute of Management Technology, India. David Tripe from School  of Accountancy, Economics and Finance, Massey University and Prague University of Economics and Business. Mamiza Haq from University of Newcastle, United Kingdom. Mui Kuen Yuen from School of Accountancy, Economics and Finance, Massey University, New Zealand.)

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