Decline in Banks’ Outstanding Credit-Deposit Spread in India

Decline in Banks’ Outstanding Credit-Deposit Spread in India

Subject: Economy

Section: Monetary Policy

• According to recent data from the Reserve Bank of India (RBI), the net interest spread between outstanding loans and deposits of banks in India has experienced a significant compression, reaching an 8-year low in August 2023.
• The spread between the weighted average lending rate (WALR) and weighted average domestic term deposit rate (WADTDR) for both fresh and outstanding rates has been dwindling. This decline in the spread, particularly impacting Net Interest Margins (NIMs), has put pressure on the banking sector.
• Private banks have consistently maintained a higher spread compared to public sector banks, leading to faster rate transmission in private banks.
• The rise in credit off-take, including the effect of the HDFC-HDFC Bank merger, has contributed to increased credit growth, especially in the personal loans segment.
• However, despite the challenges, total deposits have seen a year-on-year increase, further highlighting the evolving dynamics in India’s banking sector.

Weighted average lending rate (WALR) and weighted average domestic term deposit rate (WADTDR)

The Weighted Average Lending Rate (WALR) is a metric that represents the average interest rate at which a bank lends money to its borrowers, considering the proportion of different loans and their corresponding interest rates. It reflects the overall cost of borrowing for the bank’s customers.

On the other hand, the Weighted Average Domestic Term Deposit Rate (WADTDR) indicates the average interest rate paid by a bank on the term deposits to its customers. It considers the various types of deposits and their respective interest rates in proportion to their amounts. This rate serves as a measure of the return earned by customers on their deposits with the bank.

Both the WALR and WADTDR are significant indicators in the banking sector, offering insights into the interest rate dynamics that influence borrowing and depositing activities within the economy. They play a crucial role in assessing the profitability, competitiveness, and overall performance of banks in the financial market.

Marginal Cost of Lending Rate (MCLR):

• Implemented in April 2016 as a benchmark lending rate for floating-rate loans.
• Represents the minimum interest rate at which commercial banks can lend.
• Comprises four components: marginal cost of funds, negative carry on the cash reserve ratio, operating costs, and tenor premium.
• MCLR is tied to the actual deposit rates, causing it to rise along with increasing deposit rates, subsequently leading to an increase in lending rates.

About Credit-Deposit Ratio: Understanding its Significance and Implications

• The Credit-Deposit Ratio (CD ratio) serves as a critical metric for assessing the health and liquidity of banks.
• It signifies the proportion of total advances made by a bank in relation to the total deposits it has accumulated.
• The formula for calculating the CD ratio involves dividing the total advances by the total deposits and then multiplying the result by 100.

Implications of CD Ratio:

1. Insight into Resource Utilization: A CD ratio of 75%, for instance, indicates that three-fourths of the bank’s deposits have been channeled into loans. A lower ratio suggests that banks are underutilizing their resources, indicating poor credit growth. Conversely, a high ratio reflects heavy reliance on deposits for lending, which can pose risks, particularly in the event of unforeseen fund requirements.
2. Reflection of Banking Health: The CD ratio provides valuable insights into a bank’s liquidity and overall health. It offers an understanding of the bank’s lending practices and its ability to manage asset-liability mismatches.
3. Indicator of Economic Activity: The CD ratio is not merely a banking metric; it serves as a broad indicator for assessing inter-state disparities in banking development and the role of banking in economic activity. It helps in evaluating the credit market’s vibrancy within a specific region or economy.

While the Reserve Bank of India (RBI) does not mandate specific minimum or maximum levels for the CD ratio, it remains an essential tool for evaluating banking performance and its contribution to the broader economic landscape.

Understanding GDP and ICOR in India

GDP, or Gross Domestic Product, serves as a primary indicator of economic performance, reflecting the total value of goods and services produced within a countryover a specific period. However, it doesn’t account for factors like efficiency, income distribution, and institutional quality, which are crucial for sustainable growth.

ICOR, or Incremental Capital Output Ratio, evolved from the Harrod-Domar Growth Theory. It signifies the relationship between fresh investments and economic growth, indicating the additional capital required to generate a 1% higher output.

A lower ICOR implies greater capital efficiency and productivity.

Factors Impacting India’s ICOR Decline

• Economic Diversification: The shift to a services-oriented and technology-driven economy has reduced the capital intensity of economic activities, aiding a lower ICOR. Innovations like the Unified Payments Interface (UPI) showcase this trend.
• Decentralized Manufacturing: The adoption of 3D printing and other technologies in manufacturing has minimized the need for heavy capital investments in centralized factories, contributing to a declining ICOR.
• AI and Machine Learning Integration: The integration of AI and ML in various sectors, such as healthcare and agriculture, has improved efficiency and productivity, resulting in a reduced ICOR.

Limitations of ICOR as an Economic Indicator

• Informal Economy Impact: The extensive informal sector’s contributions may not be adequately captured in ICOR calculations, affecting the accuracy of the indicator.
• Price Distortions: Inflation and deflation can distort the relationship between investment and output, potentially misleading ICOR
• Infrastructure Bottlenecks: Despite the declining ICOR, persistent infrastructure bottlenecks can hinder overall economic efficiency and productivity.
• Regional Disparities: Regional variations can mask disparities, necessitating a more nuanced approach to ICOR
• Natural Resource Depletion: ICOR might not fully account for the depletion of natural resources, posing long-term sustainability challenges.