In the ongoing dialogue about the health of India’s banking amidst elevated Credit-Deposit (C-D) ratio and sluggish deposit growth, three topics continue to spark debate: Is mutual fund investment bank deposits agnostic? what determines bank deposits in India? and should banks act or wait for the system to autocorrect?

Addressing the first puzzle; let’s start with the assertion that mutual fund investments are bank deposit agnostic. Traditional wisdom holds that since mutual funds process transactions through the banking system, they do not drain bank deposits. Money moves from individual savings accounts to mutual fund accounts, but it stays within the banking system. However, emerging data and trends suggest a more complex relationship that merits scrutiny.

TREPS push

Recent developments reveal that mutual funds are increasingly favouring Tri-party Repo (TREPS) over traditional bank deposits. TREPS offer an attractive mix of safety, liquidity, and competitive returns, particularly in high-interest environments like the current scenario. These instruments are favoured by fund managers for their ability to meet liquidity needs without disrupting investment strategies.

For instance, the TREPS market in India has seen explosive growth, with average daily turnover surging from ₹2.13 trillion in FY19 to ₹8.0 trillion in mid-2024. Mutual funds play a pivotal role, contributing 66 per cent of the lending side in this market while public sector banks (PSBs) lead on the borrowing side with a 45 per cent share in H2 FY24.

This shift means that while mutual fund investments might not directly drain bank deposits, they do shift the funds into different short-term borrowing channels, influencing the deposit dynamics within the banking sector.

The second puzzle concerns the factors that drive bank deposit growth in India. Contrary to the belief that interest rate variations are the primary drivers, a 2019 RBI study suggests that income effects are more influential than price effects in driving deposit growth.

While short-term interest rate fluctuations and capital market performance can impact deposit growth temporarily, income and financial inclusion are long-term structural drivers of bank deposits in India. The findings remain relevant even today.

As the Indian economy continues its impressive growth trajectory, the capital markets and professionally managed mutual funds have become more alluring, potentially drawing funds away from traditional bank deposits.

The recent moderation in the elevated C-D ratio though triggers the hope of self-corrected C-D ratio to the long-run average, the question that needs to be answered is whether a diverse banking ecosystem like ours can afford to wait for this autocorrection?

Moreover, the upcoming rate easing cycle through robust transmission mechanism may bring an end to the reversal cycle by boosting credit demand, which will be further amplified by the upcoming festive seasons and revival of the rural economy. Profit booking by banks in the investment portfolio due to moderation in bond yields will support further loan growth.

Several factors have recently contributed to the leakage in deposits from banking channel; including, delay in drawing down of surplus cash balances of the government due to general election related restrictions, higher tax outflows owing to better compliance, embracing of efficient cash management mechanism of the government by welcoming Just-in-time mechanism for both centrally sponsored and central sector schemes, General as well as State election related spendings, RBI policy on increased risk weights on unsecured lending, popularity of mutual fund investments, high inflation, consumer leverage, small savings schemes, etc. Some of these may be permanent.

Given this shifting landscape, banks face a pressing challenge to revitalise deposit growth amid rising competition from capital markets and evolving consumer behaviour. One potential solution is to offer competitive deposit rates, but unlike mutual funds or equity market investments, bank deposits are a distinct asset class that guarantees returns. As the regulated end-use of deposits restricts lenders’ ability to deploy funds more profitably, offering competitive card rates may strain banks’ Net Interest Margins (NIM) and may not be sustainable in the long run.

An alternative strategy involves reassessing and innovating deposit mobilization techniques. Banks need to adapt to cyclical swings and changing household behaviour to better align their asset-liability management (ALM) with dynamic deposit growth strategies by altering appropriate card rates. This might include targeting different customer segments, enhancing digital offerings, and improving the overall attractiveness of deposit products.

The argument that tax treatment might level the playing field between bank deposits and mutual funds is also weak. Deposits are taxed on an accrual basis, while capital market investments are taxed upon redemption. Recent amendments to the Finance Bill 2023, which equated the tax treatment of debt mutual funds with fixed deposits, have not significantly impacted the flow of funds between these asset classes.

Is the elevated C-D ratio a systemic concern? As RBI’s approach to managing money supply and liquidity is critical, while increasing high powered money supply could theoretically boost bank deposits growth, and resolve the whole issue, RBI’s current focus of controlling inflation and maintaining a slightly deficit liquidity environment is more important.

RBI’s thrust

RBI has been urging banks to re-evaluate their deposit mobilisation strategies and adapt to structural shifts in public savings behaviour. By managing system liquidity and providing durable liquidity support as needed, RBI aims to maintain financial stability while also addressing deposit growth concerns.

The interplay between mutual funds and bank deposits reveals a complex financial ecosystem influenced by a variety of factors. While mutual fund investments do not directly drain bank deposits, the shift towards instruments like TREPS and evolving consumer behaviour have a nuanced impact on deposit dynamics.

Banks must navigate these challenges by adopting innovative deposit strategies, improving their deposit product offerings, and staying attuned to regulatory changes. As India’s financial landscape evolves, a strategic approach to deposit mobilisation and asset-liability management will be crucial for sustaining growth and ensuring financial stability.

Ultimately, understanding and adapting to these dynamics will be key for both financial institutions and individual investors, ensuring that the broader economic engine continues to function smoothly and efficiently.

The writer is Senior Economist, State Bank of India. Views expressed are personal