What’s threatening bank credit growth?

Two reasons likely explain this unusual trend: the lagged impact of monetary policy, and the fact that rates are often raised precisely to dampen inflationary pressures fuelled by exuberant growth in GDP and credit. The credit surge of 2004-2008 was not subdued by gradual tightening. In 2009, bank credit made a quick recovery after the global crisis, despite rates being rapidly hiked back to pre-crisis levels. There have been as many credit growth episodes during monetary easing as during tightening.

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But this policy tightening cycle is the steepest that India has seen since 2000. It is also fully loaded onto the repo rate, rather than being distributed between hikes in interest rates and other policy tools such as the cash reserve ratio and statutory liquidity ratio. And it follows two global macroeconomic shocks—the pandemic and the Ukraine war. Whether bank credit can grow robustly in this environment will depend on other factors that influence the supply of and demand for credit.

Deposit Migration

Banks need deposits to fund credit growth. When interest rates go up, depositors have an incentive to move their money to higher-yielding assets. Historically, bank deposits had low flight risk as they were seen as safe financial assets. In March 2022, individual deposits, which tend to be “sticky”, accounted for 53% of bank deposits, and a bulk were term deposits of longer than a year, which are typically held to maturity.

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But deposits cannot be taken for granted in a world of rapid information sharing and mobile banking. There is some evidence of depositors becoming more rate-sensitive: private sector banks, which offer higher rates, have shown stronger deposit growth. The removal of capital gains tax benefit on debt funds favours bank deposits, but the increase in small savings rates does the opposite. In the current inflationary environment, banks may have no choice but to raise deposit rates if they wish to attract household savings.

Credit Demand

Higher rates discourage borrowing and push up defaults on existing loans. Together, these can dry up the demand for credit. However, the exact opposite situation is playing out now. Bank credit is seeing a broad-based growth across population groups, states, loan types and sectors. Such a rise in sectoral deployment of credit has not been seen since 2010-11 and 2018-19 (when the increase was much lower). A decline in bad loans and the Budget’s thrust on infrastructure spending also favour additional lending.

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Nevertheless, two concerns need to be addressed. First, the rising exposure of banks to retail credit is risky. The stressed assets ratio (NPAs plus restructured advances to total advances) for personal loans increased slightly from 2.1 in March 2020 to 2.8 in September 2022, raising the possibility of slippages in asset quality. Second, bank credit to industry has a stronger multiplier impact on economic growth than retail credit, but industrial lending remains subdued.

Maturity Mismatch

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A rate hike impacts banks in opposing directions: interest income from loans rises, but the market value of bond investments declines. A bank that holds deposits that are payable on demand but invests in long-term fixed-rate assets faces what is called a ‘maturity mismatch’, as seen during the insolvency of Silicon Valley Bank. A bank that holds longer-term deposits but lends in the short term will lose out on interest income, the other kind of maturity mismatch. An RBI analysis shows that in 2021-22, banks were heavy on short-term deposits, and moderately heavy in terms of longer-term assets. This is normal. But the events of 2022-23 may have changed the mix. Despite higher interest rates, the incremental-credit-to-deposit ratio has shot up, while deposit growth remains slow. Short-term investments have also gone up. Unless the liability side picks up, preferably via low-cost deposits, banks may be exposed to a maturity mismatch.

The author is an independent writer in economics and finance.