Growth in bank deposits has been slow because RBI wants it to be slow

In June, bank deposits (excluding HDFC’s merger with HDFC Bank effective from 1 July 2023) grew 10.7%, whereas bank loans grew 13.9%. As of 9 August, bank deposits had shown a yearly growth of 11.7%, whereas bank loans had grown 18.4%. This is the latest data available, and the difference has persisted for a while now. As Shaktikanta Das, the governor of the Reserve Bank of India, said in July: “This may potentially expose the system to structural liquidity issues."

Misguided explanations for the deposit-lending gap

Multiple explanations have been offered by so-called experts for this discrepancy. The most common one is that people are buying more stocks and mutual funds, leading to slower growth in deposits, which, in turn, hampers the ability to fund loans. As governor Das noted: “To be precise, households are increasingly turning to other avenues for deploying their savings instead of banks."

Financial influencers have written lengthy threads on this topic. The business media has published numerous articles explaining how increasing investments in stocks and mutual funds are resulting in less money flowing into bank deposits. TV shows have also covered this extensively.

On the face of it, it sounds like a perfectly logical explanation. I invest more in stocks and mutual funds, so, by default I invest less in bank deposits. Now, as I have often explained in the past, what makes sense at an individual level, doesn’t necessarily make sense at an aggregate societal level. The economists call this the fallacy of composition.

So, one needs to remember that stocks and mutual funds aren’t black holes. The money invested in them doesn’t disappear. There are two sides to any economic transaction. If someone is buying more stocks, someone has to be selling them as well. So, those buying need to pay those who are selling. And this settlement happens within the banking system, with the money moving from one bank account to another.

Read this | War for deposits: Banks’ biggest headache now coming for investors?

So, saying that deposits aren’t growing because people are buying more stocks and mutual funds, is wrong. But there is some nuance to this. There has been a jump in individual retail investors buying stocks and mutual funds. There has also been a jump in promoters of firms listed on the stock market, selling stocks.

As a recent report in The Economic Times pointed out, in 2024, promoters of over 250 companies have sold shares worth ₹97,000 crore. This might have changed the composition of savings. Households, which individual retail investors are a part of, may be saving less in deposits, and corporates may be saving more. But it could also be that promoters might be selling shares in their individual capacity.

Also, there have been a spate of initial public offerings (IPOs), where firms have sold shares to get listed on the stock market. In this case, again the savings of households in deposits may have gone down and that of corporates might have gone up. But again, promoters of these firms and investors in these firms might be selling shares in their individual capacity.

To cut a long story short, anyone suggesting that deposits are not growing because people are investing more in stocks, mutual funds or even financial derivatives for that matter, either does not understand the issue at hand or is trying to mislead. I feel it’s more of the former than latter.

Another argument that has been made is that banks themselves are responsible for this. Customers walk into a bank to save money in deposits and relationship managers sell them mutual funds, insurance and other financial products. Hence, money doesn’t go into deposits but into other products. The fallacy of composition is at work again.

Where will this money being invested in these financial products ultimately end up? In a bank deposit. You invest in an equity mutual fund, which in turn buys stocks. Someone has to sell those stocks. The money ends up in a bank account. The same logic works when investing in insurance.

Another argument that has been made is that foreign institutional investors (FIIs) have been selling Indian stocks, and hence, taking the money out of the country. And this creates a shortage of money in the country. Again, the lack of understanding of the issue clearly comes out.

How? When FIIs sell Indian stocks they get paid in Indian rupees. But when the repatriate this money they have to convert it into dollars or other foreign currency, and hence, sell the rupees they had got.

Also, the fact of the matter is that as of 24 August, the FIIs had invested around $7 billion or ₹58,313 crore into Indian stocks and bonds during this financial year (from April onwards). Of course, a bulk of this investment is in bonds. (People who argue that FIIs are taking money out of India forget that they don’t just invest in stocks, they also buy bonds.)

Yet another argument offered is that the black money in the system has been going up and hence, deposit growth has slowed down. The currency to gross domestic product (GDP) ratio (or the cash in the financial system) as of March 2024 stood at 12% of GDP. GDP is a measure of the size of an economy. It was at 12.5% of the GDP as of March 2023 and 13.3% as of March 2022 (Those looking for the source of this data can look at Page 279 of the Reserve Bank of India’s latest annual report.)

At 12% of GDP, it is at more or less similar levels of where it was before demonetisation. So, cash in the system is stable. Given this, offering black money as an explanation doesn’t quite work.

Hence, what all this tells us is that all the conventional explanations offered for the slow growth in deposits, are basically incorrect. So, what is the right explanation? Before we get to that let’s try understanding one more thing.

The reality: Loans create deposits

Finance minister Nirmala Sitharaman recently recently asked banks to step up deposit mobilisation and conduct special drives. Such an instruction again basically stems from first order thinking and the lack of understanding of fallacy of composition.

So, banks aren’t raising enough deposits to be able to fund loans. They need to put in more effort. They will put in more effort and will be able to raise more deposits. QED. The trouble is, it doesn’t really work like that.

Let’s try understanding this through a simple example. Let’s say one bank decides to become very aggressive when it comes to raising deposits. It organises deposit melas all across the country. And in the process manages to grow deposits at a faster pace than it had in the past. But this faster growth will come at the cost of all the other banks in the financial system simply because at any given point of time there is only so much money going around in the financial system. So, if one bank decides to become aggressive and raise more deposits, it leaves a lesser amount of money for others to borrow, which will also force them to become aggressive.

Hence, what works for a single bank, may not work for the system as a whole. Or as Ananth Narayan, who is now a wholetime member of the Securities and Exchange Board of India (Sebi), had written in an August 2022 piece: “Exhorting the system to somehow “raise deposits"… makes little sense."

So, what makes sense? We are not ready to come to that. A few more things need to be understood.

Over the years we have been taught that deposits fund loans. Banks raise deposits and then use them to give out loans or credit as it is more fancily referred to as. To be honest I have been guilty of saying this in a lot of my writing as well. Originally, because of a lack of understanding and then simply because it was just easy to offer this explanation, given that the real explanation was way too complicated and long (as this piece has turned out to be.).

Deposits don’t fund loans: Loans create deposits. Yes, dear reader, you read that right, loans create deposits. And over the years, you have been taken for a ride by everyone who has said that deposits fund loans. And this is a long list: banking regulators, bankers, financial experts, economists, writers of textbooks on economics, those in the business of managing other people’s money, journalists, and more recently, the finfluencers.

More here | If deposits are stuttering, how will banks manage the credit boom?

So, how does this really work? A 2014 bulletin titled Money creation in the modern economy published by the Bank of England, points out that a bank giving out a loan “does not typically do so by giving" the borrower “thousands of pounds worth of banknotes". It credits their bank account with a deposit equal to the size of the home loan.

Further, David Orrell writes in Quantum Economics, that when a bank lends money “it doesn’t scrape together the amount by borrowing it from its clients’ savings accounts – it just makes it up by entering it in their computer system."

Hence, a bank creates a deposit of the same amount as the loan, in the bank account of the individual taking the loan. In the process it creates new money. Yes, banks create money, out of thin air. So, at the risk of reiterating, when you go to a bank to take a loan, the bank doesn’t move money from the accounts of depositors it already has, in order to give you that loan. It creates new money. While, the loan is an asset for the bank, the deposit made is a liability.

Dear reader, you might now be wondering now that if a bank can create money out thin air, why does it need deposits? Well, that’s a good question. The money given as a loan will ultimately be spent and thus it’s more than likely to move out of the account of the person taking the loan. It might move out into the bank account of another individual or a firm for that matter. Now every asset needs a balancing liability. When the money taken out as a loan moves out, the asset and the liability don’t match. To fill this gap, banks need deposits.

Or as an article titled The Truth About Banks published by the International Monetary Fund and written by Michael Kumhof and Zoltán Jakab points out: “Once purchases have been made [using loans] and sellers deposit the money, they become savers… but this saving is an accounting consequence."

The trouble is that this basic point seems to have been forgotten and “as a result is overlooked in many policy debates," like is the case in India right now.

So, to summarise, lending by banks creates deposits. Or as Kumhof and Jakab write “policy should place priority on an efficient financial system that identifies and finances worthwhile projects, rather than on measures that attempt to encourage saving, in the hope that it will finance desired investment."

Further, this does not mean that banks can create an unlimited amount of new money. There are limits. The loan creation is limited by the amount of capital that a bank has. Also, the lending is limited by the confidence that a bank needs to have while giving out a loan, that the loan is more than likely to be repaid. Or if I were to put it slightly technically, there are only so many prime borrowers out there.

RBI's role and implications for deposit growth

Now, getting back to the issue at hand. In 2023-24, the bank lending (excluding the merger of HDFC with HDFC Bank) grew 16.3%, after growing 15% in 2022-23. As a percentage of GDP, the overall bank lending as of March 2024 (at the end of 2023-24) stood at 53.8%, higher than 50.4% in 2021-22 and 50.7% in 2022-23, and also higher than years before the pandemic. Of course, this increase is because of the increase in retail loans given by banks, with corporate loans shrinking.

So, the lending growth of banks is robust and that should have created an adequate amount of deposits? Well, as it turns out, banks are not the only ones creating money. As Neelkanth Mishra, currently the chief economist of Axis Bank and also a member of the Prime Minister’s Economic Advisory Council, wrote in a June 2023 column in the Business Standard: “All the money that we see in the economy is either injected by the Reserve Bank of India (RBI) or created by banks."

Other than banks creating money, so, does the RBI, as India’s central bank. How does the RBI do this? It carries out open market operations by buying and selling bonds. When it wants to inject money into the financial system it buys bonds from banks and other financial institutions and gives them rupees, and when it wants to take out money it sells bonds and gets paid in rupees.

Other than this, the RBI also tries to manage the value of the rupee against the US dollar. When it has to prevent the rupee from appreciating, it buys dollars and sells rupees. And when it has to prevent the rupee from deprecating, it sells dollars and buys rupees. In these ways, the RBI can manage the total amount of money in India’s financial system.

Further, as Mishra writes: “[the] money injected by the RBI…is referred to as base money or narrow money." How has the narrow money grown over the years? Take a look at the following chart.

As the chart shows, the narrow money growth has slowed down over the years. At the end of 2017-18, the narrow money had grown by 21.8%. This was primarily because the RBI was replacing money it had demonetised in November 2016. And hence, an anomaly.

In 2020-21, the narrow money grew by 16.2%. The RBI created and injected money into the financial system, in order to drive down interest rates in the aftermath of the pandemic. This newly created money also helped the government indirectly monetize a significant part of its fiscal deficit or the difference between what it earns and spends. Of course, this was one of the reasons behind high inflation as well, with more money chasing the same set of goods and services. The retail inflation as measured by the consumer price index was 6.2% and 5.5%, in 2020-21 and 2021-22, respectively.

In the last few years, the growth in narrow money has slowed down. In 2023-24, it grew 7.3%, after growing 6.9% in 2022-23, and this is a major reason behind the slowdown in deposit growth. Or as Mishra wrote: “In India, due to double-digit nominal GDP growth, money supply must also grow at a corresponding pace, often in double-digits; if the growth in money supply fails to match this pace, it can lead to tightening financial conditions." The term tightening financial conditions basically refers to the slowdown in deposit growth.

So, why is RBI not creating money at as fast a pace as it was in the past? The answer might lie in the high inflation, which the central bank has been struggling to manage.

From 2020-21 to 2023-24, the retail inflation has been higher than 5%. In the last two financial years, retail inflation was 6.7% and 5.4%, respectively. This was primarily on account of high food inflation which stood at 6.6% and 7.5%, respectively. Food items form have a little over 39% weight in the consumer price index which is used to calculate retail inflation.

Now, the RBI cannot do much to control food inflation. Nonetheless, its mandate is to control retail inflation, of which food inflation forms a very substantial part. So, what does it do then? As former RBI governor Raghuram Rajan had said in a 2016 speech: “Some argue, rightly, that it is hard for RBI to directly control food demand through monetary policy. Then they proceed, incorrectly, to say we should not bother about controlling CPI inflation."

Rajan further pointed out: “We can control demand for other, more discretionary items in the consumption basket through tighter monetary policy. To prevent sustained food inflation from becoming generalized inflation through higher wage increases, we have to reduce inflation in other items."

So, the RBI is trying to bring down inflation or the rate of price rise in non-food items, and in the process, control retail inflation. In 2024-25, the retail inflation, from April to July, has stood at 4.6%, with food inflation at 8%. The core inflation, which excludes items of food group, fuel and light group, and petrol, diesel and other fuels for vehicles, has stood at 3.4%.

So, in order to control retail inflation, the RBI is ensuring that the increase in narrow money that it creates, happens at a slower pace than has been the case in the past, because at its simplest level more money chasing the same set of goods and services leads to higher prices.

Also read | How Shaktikanta Das is fixing the problem of wayward bank interest rates

This in a way explains why deposits have been growing at a slower pace. The RBI hasn’t been creating/injecting enough money as it had in the past. But there are a few more points that need to be explained here.

First, let’s look at the overall money in the system, or what is referred to as broad money. Through the 2010s and before demonetisation was carried out, the broad money to GDP ratio was around 84-85%. At the same time, the bank credit as a proportion of the GDP stood at around 52-53%. In 2022-23, the bank credit to GDP stood at 50.7% of the GDP, whereas the broad money to GDP was 82.9%, not at its previous optimum level. This was primarily on account of RBI increasing narrow money at a slower pace to control inflation, and hence, banks found it difficult to raise deposits.

In 2023-24, the bank credit jumped to 53.8% of the GDP (excluding the merger of HDFC with HDFC Bank), whereas the broad money stood at 84.1%. A bulk of the increase in broad money happened because banks gave out loans at a faster pace than in the past and in the process created more broad money. But it didn’t lead to the creation of enough deposits because again RBI was creating narrow money at a slower pace to manage non-food retail inflation.

Second, the pace of increase of narrow money after March 2024, has been slightly faster than it was before that. As of 9 August, the latest data available, it had increased 8.3% in comparison to a year earlier. So, I guess, the RBI is trying to quietly address this issue.

Third, Soumyakanti Ghosh, the chief economist of the State Bank of India (SBI), in a recent piece in the Business Standard, blamed the slowdown in deposit growth on leakages of money from the system, including the way the Union government now disburses money under the centrally sponsored schemes that have a matching share by the state government, in a just-in-time manner. I haven’t been able to get my head around this argument completely, because this money, even though delayed, does reach the banking system.

Fourth, on the same occasion that RBI governor Das said that “households are increasingly turning to other avenues for deploying their savings instead of banks," he also said “it is, of course, recognized that almost every loan creates a new deposit". So, it makes one wonder then why blame those investing in shares and mutual funds because this way or that way the money is ultimately going to end up in the banking system, though not necessarily under household savings.

Fifth, economics is a subject of on the other hand. If you want to achieve one thing, something else might also happen, simply because real life doesn’t always play out linearly. Nonetheless, the trouble is we are all brought up writing exams in which questions have only one right answer. And that is the kind of linear thinking that trickles down into our everyday lives as well. In this case, it could clearly be seen when so many so-called experts confidently blamed the stock market for a slowdown in deposit growth of banks.

Finally, in this era of finfluencers wanting to increase the number of followers almost on a daily basis, generation of regular content has become very important.

Which is why so many people jumped to explain how stocks, mutual funds, financial derivatives and FIIs are taking away money from bank deposits: but they are wrong.

The trouble is that every explanation that sounds sensible at a first order level, doesn’t always hold. I wish it was as simple as that. It took me close to two months to think through this. Economics is all about the thinking that happens after first-order thinking.

I’ve been thinking about this since July, and I’m still not sure I’ve covered everything that needed to be said. But these thoughts have been swirling in my head for the past few days, and now they’re finally out. If nothing else, this will bring some mental peace for a few days—at least until the next newsletter, which will hopefully be a more fun piece to write.