Will An RBI Rate Cut Help Or Harm Indian Banks?

All’s not well in the Indian banking sector. Although its vitals are holding steady, something is shifting beneath the calm surface that portends tough times are coming. 

A recent report by financial services company Goldman Sachs said that the Indian banking system’s era of strong expansion and significant profitability is over. Goldman sees three challenges: high cost of funds, deterioration in loan quality, and rising operating costs. Its analysts have downgraded the sector as a whole but said a rate cut by the Reserve Bank of India (RBI) could ease the situation. 

Yet, savings behaviour has changed so much in the past three years that if the RBI were to cut rate cuts now, that could hasten the structural shifts and may even adversely impact some banks.

Until now Indian banks were enjoying what Goldman described as the “Goldilocks period” of cheap funds and high margins. It also led them to lend indiscriminately which ultimately affected their asset quality. Prolonged effort from the central bank, initiated during the term of former governor Raghuram Rajan, helped shrink the Rs 10.3 lakh crore mountain of bad loans which added up to 11.2% of the system’s advances in 2018. Banks finally brought the gross non-performing asset down to 3.2% in September 2023 and set themselves up to finance the revival of the post-pandemic economy. 

 

The CASA Conundrum

While both public and private banks have sustained their credit growth, deposit growth, particularly CASA—bankers’ speak for current accounts and savings accounts—has been falling. Among the 32 listed banks, 31 have reported a year-on-year CASA decline, and the exception, Tamilnad Mercantile Bank, saw it move up slightly from 29.58% to 30%. On a quarter-on-quarter basis, more banks have reported a decline in their low-cost deposits compared to those who reported an increase. The Goldman report pointed out that among the banks it covers for clients, the CASA ratio declined from an average of 44% in the fourth quarter of FY23 for the top 6 banks to only 39% in the third quarter of FY24.

 

The problem with this segment shrinking is this money largely comprises the savings of Indian households and forms about 90% of banks’ “core deposits”. About 15 years ago, when the Reserve Bank of India (RBI) was debating full deregulation of interest rates, one of the contentious points was that it would trigger an unhealthy race among banks to corner deposits and could create asset liability mismatches. 

“Although savings bank deposits represent short-term savings and withdrawable on demand, a large part of savings deposits is treated as ‘core’ deposits, which together with term deposits have been used by banks to increase their exposure to long-term loans, including infrastructure loans,” an RBI paper had then said. A rate cut now has the potential to trigger this risk. 

The latest RBI data on the flow of financial assets and liabilities shows that households’ net financial assets plunged from 11.5% of GDP in FY21 to 5.1% of GDP in FY23. In gross terms, it fell from 15.4% to 10.9% of GDP.  During the two years, banks’ share in total household deposits in the financial sector fell from about 97% to 93%. 

During a post-budget media interaction, Vivek Joshi, secretary of financial services, from the finance ministry, highlighted a growing concern for banks: the shift of savings money from banks to mutual funds (MFs). Booming stock markets and heavily taxed deposits are gradually pushing customers away from the safety of banks for the high-risk, high-reward world of equities. RBI data shows between FY21 and FY23, bank deposits’ share in overall financial assets fell from 39% to 32% while the share of mutual funds grew from 2% to 6%. 

Part of it was the banks’ own doing. 

“We had a target of selling insurance and MF products. So we tend to push for such products to the customers,” said a senior official of a public-sector bank (PSB) requesting anonymity. Now they are scaling back. In January, the State Bank of India (SBI), Indian Bank, and Bank of Baroda ordered their zonal heads to not conduct any wealth business campaigns to sell life, general, and health insurance policies or mutual funds.

“Banks need to make schemes related to current account and savings accounts more lucrative. For example, in the case of a current account or LLP account (limited liability partnership), for a certain amount, there could be an interest rate. That could be around 2-3%. But that will make it somehow attractive,” said BN Mishra, former chief general manager of Punjab National Bank. 

This is where things get a little tricky. 

Fight Club

If the RBI cuts rates, banks will also have to reduce deposit rates, which will distance savers from banks even more. On the lending side, high-quality borrowers will demand lower interest rates. The pressure will squeeze margins, which are already under pressure. Banks will also face competition from new entrants such as payment banks and fintech startups, which will reduce the time money lies in CASA. 

Large shadow banks such as Bajaj Finserv, Shriram Finance, Muthoot Finance, L&T Finance and Aditya Birla Finance are already snatching consumer lending business from commercial banks. Household borrowings from non-banks rose from 18% in FY21 to 23% in FY23 while banks’ share dipped from 81% to 76%. Ease of transactions and affordable terms are pushing borrowers towards non-bank lenders. 

While banks face pressure from non-bank entities in retail lending, they will also have to contend with competition from private credit in the future. For instance, UAE’s sovereign fund Mubadala and Goldman Sachs last week announced a $1 billion private credit kitty for companies in Asia Pacific, with a particular focus on India. Japan’s Mizuho Bank showed off its big-corporate relationships in India at an event in Mumbai. Foreign banks have an exclusive hold over banking’s most lucrative piece—acquisition and buyout financing. Indian banks are not allowed entry into that room by regulation due to its risky nature.  

All of this means that banks need to change. 

 

Get Up, Get Going

“Bankers will have to do real banking now,” says Pronab Sen, economist and former chief statistician of India. “The time of lazy banking is over.” 

What Sen is hinting at is until now easy availability of low-cost funds and choiceless borrowers made it easy for banks. They could reject depositors and borrowers at will. Now they will have to learn the fine art of measuring and pricing risk. A big chunk of top-rated borrowers will source funds from elsewhere and banks will need to focus on MSMEs (medium, small, and micro enterprises). 

“This shift could be a painful shift. But it is a desirable one and should have happened a long time ago,” says Sen. 

Not that the industry is not aware of it. A spokesperson of the Indian Banking Association (IBA) told The Core that the quantum jump in credit growth happens mostly through corporate loans. Out of 100 MSMEs that banks may finance, chances are at worst, 10-12 of them might go bad. “We don’t lose much, but if one big corporate defaults, the risk is more,” he said. 

The problem is that Indian banks were never meant to offer term loans. That was the job of the development financial institutions while banks took care of working capital loans. That context has changed but the operating framework and mindset of banks have not.

“For MSME loans, often the banks want matching collateral. Some collateral is certainly needed for risk coverage. 
But  further to that bank could ask the start-ups to have their current account with escrow mechanism , ( wherever feasible )  for getting  an understanding of inflow-outflow of business operations , analysis of it , which gives a substantial idea about the unit’s future fund requirements and creditworthiness," said D.Sarkar, former chairman and managing director of Union Bank of India. 

 

Going Deeper On The Ground

To do all that, banks need to expand their brick-and-mortar network and hire more staff. Fintech startups have shown that technology can significantly bring down the cost of customer analytics. But relationship building is a different ball game. For that banks need feet on the ground. This is why the likes of HDFC Bank and SBI are doing exactly that. But it also means adding costs.  

Aniket Dani, director-research at global analytics company CRISIL said that an increase in penetration and branch expansion would be essential to facilitate mobilisation of CASA deposits which could lead to elevated operating costs. “It is pertinent to note that the total number of branches for banks grew at 2.6% in FY2023 which was lower than the decadal average growth rate of 3.9%,” he said.

The skewed customer-employee ratio in PSU banks and the lack of proper training for hires are the other challenges. The number of new bank branches opened between 2018 and 2023 increased by nearly 35%, as per RBI data.

 

“Both in terms of customer support and making apps/online banking more customer friendly, the banks need to fine tune, for paying statutory payments, standing instructions, advance taxes or GST (Goods and Services Tax), as there is no way to pay offline and to see that customers do not face any glitches while making the payment online as to be in personal touch or visit branch by customers are rare now a days under present banking environment . “ 
said Sarkar.

Banks will also be pressed to bring more retail customers, who currently rely on informal markets, into the system. That means designing innovative products. For instance, workers opting for the rural job guarantee scheme, MGNREGA, have no-frills accounts but they rarely use them. 

“Based on demography, economic background, and several other factors, bankers need to figure out what kind of banking facilities could be provided to the customers,” said the former managing director and chairperson of a PSU bank, requesting anonymity. “It is a wrong approach to have similar schemes across all kinds of customers.”

Clearly, the period of formulaic banking is over. 

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