Banks rebalance their asset portfolio towards the safety of Government Securities (G-Secs) when economic growth moderates or the asset quality of borrowers deteriorates, consistent with the portfolio rebalancing channel, according to an empirical analysis by senior Reserve Bank of India (RBI) officials.

At the same time, increased investment by banks in G-Secs in the face of higher government borrowings crowds out private credit, although this can be mitigated to an extent by the central bank’s market operations and the crowding-out is lower for banks with better asset quality and higher capital adequacy.

“An increase in the share of government securities in banks’ asset portfolio is found to have a favourable impact on their profitability, indicating a better risk-adjusted return on investment, although this result seems driven by public sector banks.

“Policies aimed at strengthening the asset quality and capital position of the banks can lead to an enhanced flow of bank credit to the productive sectors,” said Sanjay Singh (Director, Department of Statistics and Information Management); Garima Wahi (Assistant Adviser, Monetary Policy Department/MPD)and Muneesh Kapur (Adviser, MPD), in a working paper.

Although holdings of G-Secs impart liquidity and stability to the banking system, they can also crowd out the private sector investment by reducing the pool of the lendable funds available with the banks, the authors said, adding this can hurt domestic investment and output.

There is also evidence of a negative relationship between the government’s gross borrowings/banks’ holdings of G-Secs on the one hand and loan growth on the other, indicating the presence of the crowding-out in addition to the portfolio rebalancing phenomenon.

The paper finds a favourable impact of investment in G-Secs on the profitability of public sector banks, indicating better risk-adjusted returns on G-Sec investments relative to lending operations amidst an increase in their non-performing assets.

On the other hand, for private sector banks, G-sec investments are not found to result in higher profitability in line with the conventional wisdom of higher returns from lending relative to G-sec investments.

Referring to noted economist Luis Serven’s observations, the authors said if the increased holdings of G-Secs by the banks are associated with higher and efficient public capital expenditure, which boosts the economy’s potential output, then higher G-Sec holdings can crowd in the private sector investment.

Moreover, if the government spending is countercyclical and minimises the impact of an adverse exogenous shock, such as the COVID-19 pandemic on the economy when private spending is anaemic, then increased borrowings by the government may not lead to crowding out.

Finally, liquidity management operations by the central bank through various instruments like open market operations in consonance with the extant monetary policy stance to ensure adequate liquidity for productive purposes and the real economy can help offset the adverse impact of government borrowings on bank credit.

In view of the above, the actual holdings of G-Secs by banks at any point reflect a combination of their risk appetite, regulatory requirements, government’s financing needs, state of the economy and central bank’s market operations, the RBI officials said.

The portfolio rebalancing hypothesis posits that commercial banks prefer to shift towards safer and more liquid assets like G-Secs in stressed times - for example, when growth is weak, banks have higher non-performing loans (NPLs) and are inadequately capitalised.

Banks may prefer lending to the private sector rather than investing in G-Secs, given the higher risk-adjusted returns from such an approach.

However, banks saddled with persistently high NPLs may prefer to invest relatively more in risk-free G-Secs. In such a scenario, banks’ increased claims on G-Secs can be expected positively impact on net interest margin (NIM) and return on assets (RoA).

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