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Imbalance between bank credit and deposits

The shortage of funds has been deliberately created by the RBI to soak up liquidity first by increasing the reverse repo rate, writes DH Pai Panandiker.

india Updated: Dec 29, 2006 16:47 IST

The overnight inter-bank call money rate climbed to six-year high of 12.5 per cent reflecting the scramble for funds by commercial banks to maintain their statutory liquidity ratio (SLR). That rate is more than what banks pay to their depositors. The shortage of funds has been deliberately created by the Reserve Bank of India (RBI) to soak up liquidity first by increasing the reverse repo rate, and later by increasing the cash reserve ratio (CRR).

Until two years ago banks were replete with funds. There were not enough takers for credit and banks were forced to park their funds in government securities. But since the beginning of 2004 demand for credit jumped much more than the accretion of deposits and the credit-deposit ratio, which was loitering at around 55 per cent, climbed to 72 per cent, only three per cent less than the maximum it can go. Banks sold government securities to find money to extend credit to industry, to builders, to trade and for home loans. Now there is hardly any room for any further adjustment and the banks have to depend almost entirely on deposits to generate credit.

Since April this year, however, deposits are growing faster than credit. How long that will last will depend partly on how attractive other investment options are. Banks had slashed interest on deposits earlier until it had dropped to four per cent by 2003. Looking for better returns some investors opted for small savings, which had also suffered interest cuts but earned more than bank deposits. The Post Office Monthly Income Scheme and the Kisan Vikas Patra, which earned more than eight per cent, attracted large funds. That slowed down deposit accretion in banks.

The other more exciting option was the stock market, which, with the intermediation of mutual funds, earned much more than either the bank deposits or small savings. In 2003 when the Sensex jumped 72 per cent mutual funds mobilised Rs.47, 900 crores. When share prices slowed down the next year mobilisation substantially shrank. In April-October this year net collections by MFs were Rs.75, 300 crores.

For better mobilisation of deposits it is necessary that the interest banks pay should be commensurate with returns on other investments less the associated risk premium. That is what banks have started doing. Interest on one-year bank deposits, for instance, was increased in gradual steps from four per cent in 2003 to 6.5- 8 per cent now. That has increased the cost of funds for the banks and put pressure on the interest spread.

It was expected that banks would jack up interest on credit and curb demand. That is exactly what they are doing now. The State Bank of India raised the Prime Lending Rate (PLR) by 0.5 per cent last Tuesday, which sets the norm for other public sector banks. Currently deposits are increasing at 20 per cent and credit at 28 per cent. The eight per cent imbalance in growth rates will vanish after the adjustments in interest rates only if the stock market remains moderately bullish.

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First Published: Dec 29, 2006 16:47 IST