The withdrawal of Rs500 and Rs1,000 notes on 8 November has changed the composition of money supply in the economy. A large part of what was currency in circulation is now coming to banks as deposits. The sudden inflow of deposits has given rise to speculation about how these will be utilised by the banks. There are reports that banks will increase lending. Some have suggested that banks’ non-performing asset (NPA) problems will get alleviated. This is not correct. Our analysis suggests that: (1) banks are not in a position to significantly increase lending, (2) their net interest income (NII) may fall over the next few quarters, worsening their capital position, and (3) their NPA situation may get worse, further adding to their capital woes.
Close to 86% of the currency in circulation, amounting to roughly Rs14 trillion, was withdrawn overnight. By 13 November, Rs5.1 trillion out of this had been deposited in the banking system and Rs0.3 trillion had been exchanged over the counter. A large part of the remaining Rs9 trillion will get deposited in banks now that the exchange of old notes has been discontinued. At the same time frictions such as withdrawal limits on bank deposits, logistical constraints of re-stocking ATMs, banks’ capacity constraints in dealing with the surge in transaction volumes imply that it may take several months for the currency in circulation to even come close to its pre-8 November level.
Deposits are liabilities on a bank’s balance sheet, which they use to make loans and advances, which are their assets. However, in making these loans and advances, they have to adhere to two principles. The first is the principle of asset liability matching. This broadly means that short-term liabilities are used to generate short-term assets. If long-term loans are made using short-term deposits, banks are exposed to the risk of not being able to pay back when required or having to raise costly funds from the market to do so. The second is the principle of maintaining bank capital commensurate with the risk profile and quantum of loans made. These are according to Reserve Bank of India’s regulations and are in line with international standards set under Basel II.
First, in the current context, banks do not know how long these new deposits will stay on their books. So they can deploy these only in short-term assets. Second, the burgeoning NPAs of the banking system have significantly eroded their capital base and hence their ability to lend. In June, gross NPAs (GNPAs) of listed banks were Rs6.7 trillion or 9.1% of their advances. The 27 public sector banks (PSBs) account for 80% of these NPAs. In 15 of them, GNPAs as a percentage of advances are more than or close to the capital to risk weighted assets ratio (CRAR). Except for the State Bank of India and a few other PSBs, the CRAR headroom required to make new loans does not exist.
Given both these factors, banks will face constraints in using the new deposits to make new loans. There is also a question of demand for new loans. Corporate credit demand has been slow. The currency ban has imposed a big negative shock on consumption demand, which in turn may lead to businesses cutting back on their working capital requirement, at least in the next few quarters. This in turn will affect the demand for working capital loans.
If banks cannot make loans on these deposits, then they can either park them with RBI as reserves or invest them in government securities (G-secs). Banks would not prefer to park these deposits as reserves with the RBI beyond the cash reserve ratio (CRR) limit, because these reserves do not earn them any interest. They would prefer to invest the deposits in G-secs through the reverse-repo window. G-secs being sovereign bonds do not pose any capital requirements on banks, give them returns and allow them to match their asset liability profile.
The availability of G-secs in the market is determined by the borrowing programme of the government and is not easy to expand without raising fiscal concerns. This limits the supply of G-secs using which RBI can absorb the excess liquidity from the banks. There has been no announcement yet on the expansion of the supply of G-secs. This implies that with more incoming deposits, RBI will soon run out of G-secs that are needed to absorb the excess liquidity. This seems to be the case because RBI has now made it mandatory for banks to hold 100% CRR on incremental deposits. This announcement prevents banks from investing the incremental deposits in G-secs.
This does not augur well for banks. Their ability to make loans from the new deposits and earn income is already limited, for reasons discussed earlier. With the 100% incremental CRR requirement, the possibility of banks earning risk-free returns by investing the incremental deposits in G-secs is also removed now. Theoretically, one option with the banks is to lower the deposit rates. However, even after interest rates were deregulated, banks have not reduced deposit rates below the level of 4% that prevailed in the regulated regime. Lowering deposit rates below 4% may cause a public uproar and it is unlikely that banks will take this step. Given this, banks will have to service the cost of these fresh deposits without earning commensurate income on them. This will negatively have an impact on their NIIs and their profits, at least for the next two quarters, which in turn will cause further deterioration in their capital position.
Overall, the move to ban the Rs500 and Rs1,000 notes does not appear to be a positive one for the banking sector. They may not be in a position to significantly increase lending and their capital base may get worse. If economic activity slows down in the aftermath of the currency ban and corporate performance deteriorates, there may even be a spike in their NPAs, at least in the short term. In addition to this, bank branches all over the country have been struggling to deal with the massive transaction load that this move has placed on them. The normal banking business has been disrupted and bank employees have been occupied in dealing with exchange, deposits and withdrawals of currency. Yet the task is far from over and it is likely to keep them fully occupied till 30 December. At a time when the banking sector has been struggling to recover its bad loans and to find adequate capital to deal with provisioning challenges, this sudden shock may worsen the situation even further.
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