Banks must take cognizance of the fact that higher reliance on short-term liabilities can have its own repercussions if market conditions deteriorate, cautioned RBI Deputy Governor M Rajeshwar Rao. He also called upon them to have contingency funding plans (CFPs).
Rao said there has been a recent shift, with share of CASA (current account, savings account) deposits declining and that of term deposits (which formed 82 per cent of incremental deposits mobilised in H1FY25), especially in higher interest rate buckets, increasing. This has implications for bank net interest margins (NIMs) and profitability.
Lately, banks have also increased their reliance on short-term funding through Certificates of Deposits (CDs) and the average CD outstanding had reached levels last seen in 2012.
In his address at a BFSI summit organised by a business publication, Rao observed that “institutionalisation” of deposits will bring along specific challenges for the ALM (asset-liability management) for banks.
A reduced reliance on retail deposits, coupled with a greater share of funding from institutional sources will likely result in increased funding costs, which in turn negatively affects profitability.
“The quest to maintain the margins can lead to eventual transmission of increased funding cost to interest rate on loans. This would either constrain growth of loan book or may force the lenders to dilute the underwriting standards and lend to riskier borrowers to maintain earnings ratios.
“Banks must stay alert to the risks of certain practices that may seem less evident during strong economic growth but could lead to serious consequences during economic downturns,” cautioned the Deputy Governor.
Banks heavily reliant on wholesale funding are more vulnerable to rollover risks and outflows in times of economic stress. Therefore, effective liability management is crucial for mitigating these risks.
Contingency Funding Plans
Rao observed that in general, regulatory entities/REs (banks and NBFCs) should have formal contingency funding plans (CFPs) commensurate with their complexity, risk profile, scope of operations and their role in the financial system.
Among others, the CFP must clearly articulate the available potential contingency funding sources and the amount of funds that can be derived from these sources.
“It is important to note that the lender of last resort (LOLR) function of central banks is regarded as (implicit) insurance for 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 increases moral hazard,” the Deputy Governor said.
Rao underscored that banks need to recognise that, to address this moral hazard, the central banks retain discretion to decide whether to extend emergency liquidity assistance to specific institutions.
This 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.
Rao said the rise of innovative products and technologies in banking has enhanced consumer flexibility in accessing funds & managing cash flows, significantly transforming customer behaviour.
Key challenges
Further, the evolving dynamics of information dissemination through traditional and social media can profoundly influence customer behaviour, potentially escalating and amplifying a crisis.
“These factors present heightened challenges and banks need to be watchful and carefully review their modelling assumptions on stability of deposits and customer behaviour to better predict deposit retention, withdrawal patterns, pre-payments, and interest rate sensitivities,” he said.
The Deputy Governor emphasised that the financial assets and bank assets would need to achieve a consistent and high paced growth over the next two decades, which would require a corresponding increase in liabilities and capital for the financial sector, in order to achieve the ambitious economic growth target under the vision of ‘Viksit Bharat’ by 2047.