Indian banking has been through a phase of “problem of plenty”. Being the most leveraged intermediaries, banks crave quality credit growth. What if the demand for credit consistently outpaces the available funds?

The ongoing wedge between credit and deposit growth creates genuine concern among banks and the regulator about the sustainability of double-digit growth given that deposit growth is almost half of credit growth.

The pick-up in credit offtake during FY23 was broad-based with non-food credit offtake expanding by a hefty 15.4 per cent (notably, 15.5 per cent y-o-y as on June 2), 5.8 percentage points higher than the deposit growth (9.6 per cent).

The sensitivity of retail credit to interest rates is almost missing as they both are moving in the same direction with personal loans growing 20.4 per cent, supported by 43 per cent growth in credit against FDs, 39.4 per cent growth in consumer durables credit, 29.2 per cent growth in credit card outstanding, 23.4 per cent growth in vehicle loans, and 20 per cent growth in loans against gold jewellery.

Lower delinquency and a higher yield in the segment have led a few large commercial banks to focus on retail credit as well. While credit offtake is cyclical in nature, it is hard to predict the duration of the credit boom phase.

In its FY23 annual report, the RBI has been optimistic about credit growth and has attributed the return of consumer optimism and improvement in business outlook during FY24 to sustaining the demand for credit.

Need for liquidity

But banks need liquidity to sustain this credit growth momentum. A higher credit growth rate over deposits is always a double-edged sword. The elevated credit-to-deposit (C-D) ratio of 75.8 per cent by the end of FY23 shows the efficiency of the utilisation of banks’ core funds for lending. But a high C-D ratio is also a reflection of an overstretched balance sheet and will lead to capital adequacy issues in the coming quarters.

How are banks positioned to support the credit demand? The deposit base of banks, is their main source of funds for credit. With deposit growth trailing credit growth for more than one year in a row, banks have been aggressively competing for deposits, even though the cost of deposits has gone up with the tightening of monetary policy.

Incremental deposits for FY23 were ₹15.8 trillion vis-a-vis ₹13.5 trillion in FY22.

As of March 25, 2023, the incremental C-D ratio rose sharply to 115.2 per cent, YoY. Deposit growth has been keeping pace and is expected to be robust going forward as banks are luring customers with higher rates. The accumulation of deposits in the past few years has been a crucial source for banks in funding the growing credit demand.

Money market rates have also firmed up, as seen in the average spread between the weighted average call rate (WACR) and policy rate which declined to 12 basis points (bps) in FY23 from 75 bps in FY21.

The weighted average lending rate (WALR) on fresh rupee loans of banks increased by 181 bps to 9.32 per cent in March 2023, against a 245 bps rise in the weighted average domestic term deposit rate (WADTDR) on fresh rupee term deposits to 6.48 per cent. This rise is more pronounced for PSBs (250 bps) compared with private banks’ 214 bps.

The second important source of funding is the liquidation of surplus high-quality liquid assets (HQLA). By the end of March 2023, commercial banks had excess SLR deposits of ₹19.4 trillion, 10.1 per cent above their mandatory NDTL requirement limit of 18 per cent. Most importantly, to support credit growth, banks are drawing down their HQLAs.

This is evident as the latest RBI FSR shows that the liquidity coverage ratio (LCR) has been brought down from a high of 173.0 per cent in September 2020 to 135.6 per cent as of September 2022, hovering above the regulatory prescription of 100 per cent.

The CD route

As growing a deposit base in a competitive environment is not a viable solution in the short term, banks are resorting to raising funds through issuance of Certificate of Deposits (CDs). In the primary market, fund mobilisation through issuances of CDs has jumped by threefold in FY23, to ₹6.73-lakh crore compared to ₹2.33-lakh crore in FY22, even though the average CD rates in FY23 have been 221 bps higher in FY23 (6.39 per cent) compared to FY22 (4.18 per cent).

The spike seen in CD issuances is largely attributed to the short-term funding needs of banks to meet the rising loan demand. Corporates and money market mutual funds find CDs more attractive compared to parking funds with banks in bulk deposits due to the higher interest rates offered by the former. But CDs are a quick fix for banks and not a perfect substitute for deposits.

A few additional sources of funds (long-term) for banks are by selling Tier I, Tier II, and (green) infrastructure bonds in domestic as well as foreign markets. In a nutshell, the revival in consumer demand and the positive corporate outlook, supported by record government capex, have been the reasons for robust credit demand.

From the demand side, lower input costs (measured via wholesale price inflation), economic optimism, further reduction in the cost of borrowings in coming days (as interest rate have peaked) etc. are the crucial factors. On the other hand, intense competition for deposits and utilisation of alternate sources including, drawing down of HQLA, raising funds through CDs, exploring funds from foreign markets and reduction in credit cost supports the supply side scenario.

The well-capitalised banking system with better asset quality is expected to sustain credit demand to productive investment opportunities. While doing so, extra care must be taken to maintain the quality of assets and effective control over slippage. As is often said — all bad loans are created during good times.

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