Loan-deposit ratio to stay high, banks set to go for CDs, bonds

The health of the banking sector is a critical barometer of any nation's economic vitality, and India is no exception. The recent outlook suggesting that bank profitability is set to bottom out this fiscal year before gradually improving by FY27 offers a nuanced perspective on the current state and future trajectory of India's financial landscape. This projection is primarily driven by the anticipated easing of funding pressures and the stabilization of Net Interest Margins (NIMs), a key indicator of a bank's profitability from its core lending and borrowing activities.

**Background Context and What Happened:**

Post-pandemic, the Indian economy witnessed a robust recovery, leading to a significant surge in credit demand from both retail and corporate sectors. While this credit growth is a positive sign for economic expansion, it has outpaced the growth in deposits. This mismatch has resulted in a high Loan-Deposit Ratio (LDR) for banks. The LDR indicates how much of a bank's deposits are given out as loans. A high LDR means banks have less liquidity to meet new loan demands without attracting more deposits or raising funds through alternative means. Traditionally, banks rely on low-cost current and savings account (CASA) deposits for funding. However, with deposit growth lagging, banks are compelled to seek more expensive funding options.

To address this funding gap and maintain credit flow, Indian banks are increasingly resorting to market instruments like Certificates of Deposit (CDs) and bonds. Certificates of Deposit are short-term, negotiable money market instruments issued by banks to raise funds. Bonds, on the other hand, are longer-term debt instruments. Both these instruments typically come with higher interest rates compared to traditional savings deposits, increasing the banks' cost of funds. This increased cost directly impacts their Net Interest Margins (NIMs), which is the difference between the interest income earned on loans and the interest paid on deposits and other borrowings. When the cost of funds rises faster than lending rates, NIMs contract, thereby affecting overall profitability.

**Key Stakeholders Involved:**

Several key players are central to this scenario. **Commercial banks**, both public and private, are at the forefront, grappling with LDRs and NIM pressures. Their strategic decisions on deposit mobilization, lending rates, and capital raising through CDs and bonds are crucial. The **Reserve Bank of India (RBI)**, as the central bank and primary regulator, plays a pivotal role. Through its monetary policy tools – such as the Repo Rate, Reverse Repo Rate, Cash Reserve Ratio (CRR), and Statutory Liquidity Ratio (SLR) – the RBI influences liquidity in the system and the overall interest rate environment. For instance, if the RBI maintains a tighter liquidity stance or raises policy rates, it further increases the cost of funds for banks. **Depositors** are another critical stakeholder; their willingness to save and the interest rates offered on deposits directly impact the banks' funding base. Finally, **borrowers** (individuals, businesses, and corporates) represent the demand side for credit, and their ability to service loans impacts asset quality and bank profitability.

**Why This Matters for India and Historical Context:**

A healthy and profitable banking sector is indispensable for India's economic growth and financial stability. Banks are the primary conduits for credit to various sectors – agriculture, industry, services, and retail – fueling investment, production, and consumption. If banks face funding stress or declining profitability, their capacity to lend diminishes, potentially stifling economic activity. This situation also impacts the transmission of monetary policy, as banks' ability to pass on rate changes to borrowers and depositors is influenced by their funding position.

Historically, India has seen periods of both high credit growth and deposit scarcity. In the early 2000s, rapid credit expansion, particularly in infrastructure, led to asset-liability mismatches for some banks. The RBI has consistently worked to ensure prudent asset-liability management. The current high LDR is a reminder of the perpetual challenge of balancing credit demand with stable, low-cost funding. The government's emphasis on financial inclusion and digital payments has also influenced deposit patterns, though not always directly translating into broad-based, low-cost deposit growth for all banks.

**Future Implications and Related Policies:**

The projected improvement in profitability by FY27 suggests an expectation that funding pressures will ease, possibly due to a moderation in credit growth, an acceleration in deposit growth (perhaps spurred by higher deposit rates), or a combination of both. The RBI's monetary policy decisions will be critical. If inflation cools down, the RBI might consider easing its monetary stance, which could reduce the cost of funds for banks. Banks themselves will likely intensify their efforts to attract deposits, possibly offering competitive interest rates, especially on term deposits. This could lead to a 'deposit war' among banks.

This scenario is closely linked to several legal and policy frameworks. The **Reserve Bank of India Act, 1934**, empowers the RBI to regulate the banking system and manage monetary policy. The **Banking Regulation Act, 1949**, provides the framework for the functioning of banking companies, including their lending, deposit-taking, and capital adequacy requirements. The government's **Monetary Policy Framework Agreement** with the RBI (2015) mandates inflation targeting, which directly influences interest rate decisions and, consequently, bank funding costs. Furthermore, the **Deposit Insurance and Credit Guarantee Corporation (DICGC) Act, 1961**, ensures depositor confidence, which is vital for deposit mobilization. Understanding these acts and the tools like CRR, SLR, Repo Rate, MSF (Marginal Standing Facility) is crucial, as they are the primary levers through which the RBI manages liquidity and ensures financial stability, impacting banks' funding costs and profitability.