Rising Credit-to-Deposit Ratio May Pose Problems for Some Banks in 2023
According to the study, as of March 31, the CD ratio for state-owned banks increased by 420 basis points year over year (y-o-y) to 69.8%.
Some banks may run into trouble if their credit-to-deposit (CD) ratio increases since they must borrow at higher rates to keep up with the loan demand.
When the Reserve Bank of India (RBI) announced that it would need a 10% incremental cash reserve ratio (I-CRR), analysts predicted that this would harm the short-term liquidity of the banking sector.
Sanjay Kumar Agarwal, senior director at CareEdge, stated that although the CD ratio is presently not at worrying levels, it is more significant than previously and is anticipated to continue to climb.
In this situation, Agarwal continued, certain private sector banks—which now maintain a 90% CD ratio—would have to access the financial market, where the cost of borrowing is higher. Here, the difference between deposit and lending rates will close, which will cause the net interest margin to contract.
The CD ratio shows the percentage of deposits that banks have received used to finance loans. An excellent CD ratio is between 65-75%.
A higher ratio suggests that banks need more cash from the financial market to expand their loan book since they lack the necessary resources.
“Theoretically, the CD ratio can be higher for some banks if they have a sizeable equity capital that can be deployed to lend,” says Karthik Srinivasan, senior vice president and group head of financial sector ratings, ICRA.
According to Srinivasan, the percentage can increase if the bank obtains more money through tier-1 and tier-2 bonds.
To temporarily absorb excess liquidity from the banking system, the RBI required an I-CRR of 10% on the growth in net demand and time liabilities between May 19, 2023, and July 28, 2023, in its monetary policy statement on Thursday.
The required CRR is still 4.5 per cent. ACCORDING TO THE RBI, the I-CRR will be reviewed on September 8 or earlier to release the frozen cash into the banking system in time for the festival season. The system will have enough liquidity to support the economy’s credit demands, the central bank guaranteed, despite the “temporary impounding”.
Despite the RBI’s assurance that the I-CRR is only a temporary solution, analysts only partially rule out limiting the money supply if inflationary pressures persist.
Following the news, bank shares dropped precipitously as investors worried that they wouldn’t be able to receive interest on the money they were keeping in ICRR. If interest rates on short-term money market instruments like treasury bills and commercial papers rise, these securities will cost banks more money.
Additionally, banks would have somewhat less money to lend due to the ICRR, which will harm margins and credit growth, according to Karan Gupta, director & head of financial institutions at India Ratings & Research.
In the banking world, metrics such as the credit-to-deposit ratio (CDR) provide essential insight into the health and functioning of financial institutions. A rising CDR can indicate increased lending activity, but it might be a warning sign of potential challenges for banks when it climbs too high. In 2023, we observed a surge in this ratio for several banks, which warrants closer scrutiny.
At its core, the banking business revolves around borrowing short and lending long. Banks take in deposits and, in turn, lend out a portion of those funds. When the CDR rises, it can mean that banks are lending out a more significant proportion of the deposits they hold. This might lead to potential liquidity problems, especially if there’s an unexpected spike in withdrawal requests.
A higher CDR can also suggest that a bank is taking on more risk. Banks with a high CDR might be more exposed to loan defaults, which can harm their overall financial health, especially if the economy faces a downturn.
Regulators often monitor CDR levels to ensure banks maintain a healthy balance between their loans and deposits. High CDR values lead to increased regulatory scrutiny and can result in enforced corrective actions.
With more funds lent out, a bank with a high CDR might need to rely more on external sources for funds, often at higher interest rates. This can erode profitability and lead to increased vulnerability to interest rate fluctuations.
Post-pandemic economic recovery has instilled confidence in the banking sector, prompting more aggressive lending to stimulate growth.
Central banks worldwide have maintained low-interest rates to spur economic activity, making borrowing more attractive to consumers and businesses. The rise of fintech and digital banking platforms has made it easier for consumers and businesses to access credit, driving up lending volumes.
More prominent institutions often have diversified revenue streams and robust risk management practices. While they resist the challenges of a high CDR, their extensive capital reserves and broader customer base can offer some protection.
These institutions might face more pronounced challenges. Their localized presence and narrower operational scope can make them more vulnerable to liquidity crunches and localized economic downturns.
The relatively newer entrants in the banking world have aggressively pursued growth, sometimes at the cost of higher risk. Their resilience in the face of a rising CDR remains to be tested.
While a rising credit-to-deposit ratio in 2023 indicates robust lending activity, which can be a sign of economic optimism, it also brings to the fore potential challenges for banks.
Maintaining a balanced approach between lending activity and deposit growth and vigilant risk management will be pivotal for banks navigating this landscape. Stakeholders, from regulators to investors, would do well to keep a keen eye on this metric in the coming months.
