Are we seeing an irreversible decline in bank deposit growth ?

Banks are the traditional, centralized institutions of both deposit and credit, which serve as an intermediary between the investor and borrower. They are overly bulky and regulated institutions. There is a large degree of human intervention in deciding the interest rates, loan applications, etc. and that brings the associated inefficiency along with it.

Presently, banks globally are experiencing a structural liquidity crunch. The reasons may differ in different countries according to local financial cultures: its the same storm but different boats.

In China, PBoC’s low interest rates to boost the economy has made retail depositors to invest in gold or real estate instead of banks, and even in cash fearing a volatile economy. This has dropped the interest margins of their banks to a record low.

In the US, deposit growth has been declining since FY22 and has gone below savings rate (See below graph). This means people have started investing their household savings in market instruments like MMMFs instead of depositing in banks in order to get returns close to market rates. These MMMFs further invest into Fed’s ON-RRP (Reverse Repo) facility for liquidity management, effectively bypassing banks and hampering their deposits.

So all countries are passing through similar effects. For a thorough sample analysis, in this article I’ll analyse the case of Indian banks.

Alternatives to banks are coming up fast. Several AAA-rated NBFCs like Bajaj Finserv and Muthoot Fincorp have started providing interest rates of up to 8.5% on their FDs, making them a compelling option compared to traditional bank FDs. On the other hand, with the fintech boom and people becoming more digitally aware, esp. after the Covid pandemic, people are increasingly investing in capital markets comprising equity and debt markets, which now sit on a huge AUM of roughly ₹ 60 lakh crore, with a staggering 70% CAGR seen over the last five years. The graph below illustrates this.

Moreover the market cap of listed companies has become a staggering ₹ 400 lakh crore with a 15% CAGR. However this market cap represents the current valuation of the

market share of companies and only a small portion of it is the actual investment by investors. Hence in India, bank deposits are still the default choice for most people to store their money due to safety, liquidity, and familiarity, with the total current bank deposits in India amounting to nearly ₹ 220 lakh crore with a 10% CAGR. Over 60% of it comes from cheap household deposits (cf. just 25% ie. ₹ 100 lakh crore in case of capital market). And nearly 50% of these household deposits are from non-term CASA deposits and remaining from FDs, etc. And these CASA funds are really cheap money for banks (much below the large repo rates) : for instance, in FY24, savings deposits earned between 2.7% and 3%, while term deposits (1-3 yrs) offered rates ranging from 6% to 7%. Moreover these retail CASA deposits are more stable for banks than wholesale deposits. But people are becoming smarter now and want investments which can beat inflation. So they’re shifting from CASA towards Mutual Funds (MFs). And though these MFs re-invest a part of their folio into banks’ CDs, they do so at higher rates than CASA. So its costly for banks. Consequently this CASA average for Indian banks has dropped to 40% now, from around 50% some years back, indicating that people are doing wholesale/bulk/term deposits. (See below graph).

The situation is becoming such that banks are accepting bulk deposits at 9% and lending home loans at 8.5%, suffering a negative margin as Uday Kotak pointed out last week. These wholesale deposits again have additional costs such as CRR, SLR, LCR, deposit insurance, and PSL targets.

All this is straining banks’ tier-1 capital and pressing them to look for alternative sources of funding like CDs (which grew 34% yoy in FY25).

The lending scenario for banks is also gradually deteriorating. While the deposits crunch has reduced the deposit growth to c.11%, the lending growth is c.15%. This has pushed the Loan-to-Deposit Ratio (LDR) to an all-time high of c.80% (Graph below)

Inflation rates in India seems stably cooled after many years of post-Covid inflation and is projected to hover around 4% (US tariffs may increase it slightly) throughout FY26 . This will nudge the MPC to cut repo rates even further, forcing banks to slash their lending rates, further eroding their profit margins. Moreover US tariffs may force reducing reliance on exports and boosting domestic demand instead, which may again motivate repo rate cuts.

All these will further make banks very selective with their loan applications in order to filter out subprime borrowers and avoid potential NPAs. As mentioned earlier, since India is still majorly a bank-led economy, a contraction in bank lending can decelerate economic growth. It will also widen the already existing gap of over $300 bn in MSME financing, which primarily rely on bank loans. It will hamper the transmission of RBI’s rate cuts from banks to their customers.

Selective lending may also impact the beneficiaries of various government schemes which rely on subsidised bank loans. Many such advances are mandated under the Priority Sector Lending (PSL) policy as per which 40% of all advances of a commercial bank must go to the priority sectors. During a deposit crunch, banks with limited lending capacity might lean on even buying PSLCs/ RIDF investments with a 2% return, rather than lending to priority sectors and bearing operational challenges. I’ll discuss on PSL and other regulations in the banking sector in detail in a subsequent article.

Firstly you should understand that banks are the primary mover of money supply in the economy, even with lesser deposits, due to a multiplier effect stemming out of the fractional reserve system. Hence a deposit crunch in banks translates to an overall liquidity crunch in the economy, and vice-versa.

Now in view of the depreciating ₹ against the $, the RBI sold $77 bn from its forex reserve earlier this year in order to stabilize the exchange rate. This ballooned the existing liquidity deficit in the interbank market upto ₹ 3 lakh crore in Jan 2025, the highest since the global financial crisis 16 years back.

The deposit crunch in banks is a structural issue and only structural reforms like deregulation can solve it in the long term. However if left untackled, it can quickly spiral the economy into a crisis even in the short run. A money supply bottleneck can quickly result in liquidity and credit shocks downstream. Depositors and investors may start losing confidence in the banking system, causing possible bank runs.

So RBI stepped in Feb 2025 for some STLM. It sold over ₹ 1 lakh crore in lieu of G-secs through OMOs (contrast with the tight money policy in the last 2.5 inflation-ridden years- ref. graph below), sold ₹ 50,000 crore through 56-day VRR auctions, and sold around over ₹ 1 lakh crore through rupee/dollar forex swap auctions. By the end of March 2025, the ₹ 3 lakh crore liquidity deficit became a ₹ 90,000 crore surplus. But remember this STLM is a symptomatic, not systemic relief.