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Lenders’ reliance on short-term funds could lead to higher rates: M. Rajeshwar Rao
- At the 17th edition of Mint Annual BFSI Summit and Awards, the RBI deputy governor said the average outstanding CDs have reached levels last seen in 2012 because differentiated banks are relying more on inter-bank deposits and wholesale funding.
Indian lenders’ increasing reliance on short-term funding could have repercussions if market conditions deteriorate, hurting profitability and increasing loan rates for customers, according to Reserve Bank of India (RBI) deputy governor M. Rajeshwar Rao.
Different types of banks are relying more on inter-bank deposits and wholesale funding, Rao said at the 17th edition of the Mint Annual BFSI Summit and Awards on Friday. The reliance on short-term funding is reflected in average outstanding certificate of deposits (CDs) reaching levels last seen in 2012, he said.
“Institutionalizing deposits will bring specific challenges in asset-liability management for banks,” he said. “Less reliance on retail deposits coupled with a greater share of funding from institutional sources will likely result in increased funding costs, which can, in turn, negatively affect profitability.”
Indian banks have faced margin pressure as they chased customers to park money amid surging credit growth. Deposits continue to be the primary source of funds for commercial banks, amounting to around ₹217 trillion at the end of 2023-24 and representing 77% of total liabilities, Rao said quoting RBI data. Capital reserves and surplus, along with borrowings, constitute around 9% each of total liabilities.
Also Read: Banks added over ₹2 trillion more in deposits than loans in 2024
The “quest to maintain margins" may also lead to the eventual transmission of increased funding costs to loan interest rates, Rao said at the Mint summit. That would either constrain loan growth or force lenders to dilute underwriting standards and lend to riskier borrowers to maintain the earnings ratio, he said.
“Banks must stay alert to the risks of certain practises that may seem less evident during periods of strong economic growth but could lead to serious consequences during the downturns,” he said. Rao sees the lenders which are heavily reliant on wholesale borrowings or uninsured deposits are more vulnerable to rollover risks and outflows in times of economic stress.
Liability management
According to RBI data, deposits grew around 10% every year between 2016 and 2024, whereas borrowings grew 7% every year. As a result, the share of deposits in the funding mix has remained around 77%, whereas that of borrowings has declined to 9% from 11% over this period. Capital funds grew close to 13%, with their share rising to 9.3% from 7.6%.
A shift in household preference to financial assets is moving their savings to capital market assets in search of higher yields and portfolio diversification.
Complacency alert: The recent shortfall in deposits is a wake-up call for Indian banks
While this trend may not alter the aggregate funding available for banks, it is changing the character or mix of deposits, which has implications for banks’ cost of funds and margins, Rao said.
"Maturity transformation is thus an inherent feature of financial intermediation, and banks are strongly exposed to the associated risks. As a result, strategic management of assets and liabilities is crucial to optimize profitability, improve liquidity and protect banks against the various risks,” he said. It is now well understood that liability management is crucial not only for a regulated entity's stability and solvency but also for its return on capital as well as growth trajectory, according to Rao.
The banks’ share of low-cost current account-savings accounts (CASA) deposits has also fallen since the post-pandemic peak. However, Rao suggested at looking at CASA over the long term.
Between 2016 and 2024, the share of term deposits fell from 65.8% to 60.9% of total deposits, whereas the share of current account and savings account deposits rose from 25.3% to 29.2% and from 8.9% to 9.9%, respectively. Consequently, banks’ CASA ratios improved from 34.2% to about 39.1%, he said.
NBFC funding profile
Unlike banks, most non-banking financial companies (NBFCs) don’t have access to public deposits, and borrowing remains their most significant source of funding, amounting to ₹34.46 trillion or 68% of the total liabilities as of March 2024.
Within borrowings, non-convertible debentures (NCDs) and borrowings from banks are the main contributors, making NBFCs’ liabilities more market-driven and sensitive to interest rate changes compared to banks, Rao said. The liability profile of NBFCs is shaped by their primary activities, regulatory requirements and the type of assets they finance, he said.
“Historically, crises have demonstrated that NBFCs’ over-reliance on short-term funding to support long-duration assets, such as infrastructure and housing loans, can result in significant liquidity constraints, deterioration in investor confidence and credit rating downgrades, thereby constricting their ability to access capital markets,” he said.
Also Read: Bank deposits and mutual funds: cogs of the same wheel
As a result, NBFCs have become heavily dependent on bank funding—both direct lending and bank subscriptions to debentures and commercial papers—leading to funding concentration, which prompted the central bank to hike risk weights on bank loans to NBFCs in November 2023.
To offset this, NBFCs’, too, have increased funding through CPs, NCDs, and external commercial borrowings (ECBs).
“While accessing international markets can reduce NBFCs’ reliance on the domestic banking system and provide a broader range of funding options, it is also exposing them to additional risks, particularly the unhedged currency exposure, which can lead to volatility in funding costs and potential liquidity strains due to exchange rate fluctuations,” he said. Rao advised NBFCs to integrate forex hedging with their asset-liability management (ALM) framework and closely monitoring currency exposure to mitigate funding volatility.
“The liquidity transformation of assets through securitization to free up resources for on-lending can also serve as an important tool to improve the ALM structure,” he said.
Stress testing, contingency plans
Rao called for banks and NBFCs to “carefully review” their modelling assumptions on deposit stability and customer behaviour to better predict deposit retention, withdrawal patterns, prepayments, and interest rate sensitivities.
Regulated entities must develop more sophisticated stress testing methodologies to evaluate their ability to withstand extreme scenarios, including those that involve the amplification of shocks across the interconnected financial network.
He also called for regulated entities to set up a formal contingency funding plan commensurate with their complexity, risk profile, scope of operations, and role in the financial system, among other factors.
Also Read: The anatomy of falling bank deposits—and how to arrest it
“It must clearly articulate the available potential contingency funds, funding sources and the amount of funds that can be derived from these sources,” Rao said, adding that market participants should not rely on the regulator for emergency funding requirements.
The central bank’s ‘lender of last resort’ (LOLR) function is an implicit assurance or insurance to banks against liquidity shocks that money market participants are unwilling or unable to absorb. The value of this insurance increases with banks’ exposure to liquidity risk, which consequently increases the moral hazard, Rao explained.
He added that banks need to recognize that to address this moral hazard, central banks retain the discretion to decide whether to extend emergency liquidity assistance to specific institutions. “The assistance is intended as a safety net for the entire financial system through judicious use of public funds and is often accompanied by supervisory intervention and conditionalities. Therefore, the LOLR function should not be regarded as a routine component of contingency funding,” he said.
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Business NewsIndustryBankingLenders’ reliance on short-term funds could lead to higher rates: M. Rajeshwar Rao
First Published:17 Jan 2025, 04:00 PM IST
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