Weak bank deposit growth: Beware faulty explanations

Eventually, it turned out to be the flu and I recovered within a few days, without having to either correct my irresponsible lifestyle or inhale the recommended vapours of medicinal herbs. 

Something similar has been happening with anaemic deposit growth in the Indian banking system. It has lagged credit growth for over a couple of years now, causing commentators to look for causes and remedies.

It is important to first eliminate factors that are not causing this divergence between bank deposits and loans. Flows into capital markets via either mutual funds or direct equity participation are often wrongly blamed. 

As long as the money used to purchase a financial asset remains within the banking system, it does not affect overall deposit growth. Indeed, the same holds for savers preferring to deposit their savings with non-banks or in small savings schemes, or buying gold or property. 

These decisions change the savings pattern of households and have implications for the stickiness and cost of deposits for the banking system but not for its overall growth rate.

From a top-down vantage point, a possible framework to understand what’s going on is to think about the sources and uses of broad money (M3) and how they have changed over time. 

Put simply, there are five broad-money actors: cash in circulation (CIC), scheduled commercial banks (SCBs), the central bank, the government and the country’s financial relationship with the rest of the world (i.e. the balance of payments or BoP). Analysing interactions between these actors should help us solve today’s deposit growth riddle.

For instance, if CIC goes up, it amounts to a leakage from bank deposits and therefore cannot be on-lent. This impacts the credit deposit math. Similarly, if SCBs increase the amount of cash reserves they hold with the Reserve Bank of India (RBI), our central bank, it reduces resources available for commercial credit. The government maintaining a larger or smaller balance with the central bank also impacts this equation, as does the BoP ledger balance.

Since the sources and uses of M3 are two sides of the same equation, they have to tally. Hence, a perfect reconciliation between incremental deposits garnered and credit extended by SCBs should be possible. Unfortunately, all the required data for this reconciliation is not publicly available in a disaggregated way, at least not as of the same date.

Although a perfect reconciliation may not be possible, we can still get a sense of direction of the items to be reconciled that would help us estimate leakages from and infusions into the country’s banking system.

An increase in CIC is a leakage, but it is heartening that since fiscal year 2020-21, as a share of deposits, this figure has gradually declined, which implies that the extent of this leakage has been reducing. The rapid rise of digital payments may be one reason for this.

For 2023-24, higher government balances with RBI as compared to the previous year is another significant leakage. As a share of deposits, it went up by 0.7%, but this increase is likely to be transitory in nature, as the government eventually spends its fiscal collections. Data for the first quarter of 2024-25 confirms as much.

Banks having to maintain larger holdings of government securities (as part of their statutory liquidity ratio or SLR obligations) is sometimes cited as a reason for weak deposit growth. 

But again, as long as the money remains within the banking system, it should not affect the aggregate growth numbers. A change in the cash reserve ratio (CRR), if and when it happens, would however affect the deposit growth number.

While the two leakages outlined above are the main ones, there was significant infusion as well. This was in the form of a BoP surplus that India reported in fiscal year 2023-24.

If we now flip our lens to a bottom-up one, we can analyse incremental deposit and credit growth by looking at the aggregate balance sheets of SCBs. Again, since assets equal liabilities, we should be able to get a perfect reconciliation, and this time, as of date. 

If we compare the last reporting Friday for 2021-22 with that of 2023-24, we find that loans now occupy a slightly higher proportion of the combined SCB balance sheet, which goes along with lower SLR and non-SLR investments. 

The main story is in the composition of the liability side. Deposits now occupy only 86% of banks’ total liabilities, down by over 5 percentage points from 2021-22, and the rest is almost entirely their equity and reserves component. 

The rising profitability of banks in India, especially that of state-owned lenders, has been well documented over the past two years, and this has contributed to it. Put differently, banks have been lending more out of their equity than before, and that reflects in the system’s higher credit-to-deposit ratio.

So, what happens now? Nothing really. Incremental credit over deposits is already cooling off. From 113% in 2022-23, this measure was down to 96% by the end of 2023-24 and will likely reduce further. 

Like the teenaged me, it is coming back to normal on its own. In case of future abnormalities, though, we hopefully have a framework to analyse them. That would be better than barking up the wrong tree.