Investment strategies in turbulent times are tricky and often determine the risk appetite and trust in the institutional mechanism of the country. The aftershocks of the pandemic along with the ensuing global upheavals have kept investors on tenterhooks, in deciding their investment portfolio. In an ideal setting, with the tight statutory liquidity requirements, public sector banks often have a skewed investment in government securities while the private counterparts along with households have a relatively diversified portfolio. However, the portfolio choices of banks and households could get disturbed and inconsistent during economic shocks.
The combined investments by private and public sector banks across safe assets like government securities and into the volatile equity and debt markets have grown at a compounded annual growth rate of 9.06 per cent in the last six years. The rise in speculative investments creates channels for non-interest income for the banks but exposes them to asset bubbles and market instability. While it is no surprise that public sector banks’ investment in government securities currently constitutes 87 per cent of its total portfolio, the rapid jump of private banks into these safe havens by 11 per cent in the last six years is quite unexpected.
This trend reflects a cautious, safety-first approach, particularly in uncertain market conditions, as government securities offer stability and reduced risk exposure compared to more volatile sectors. Does this mean private banks anticipate a stressed market or is it driven by external market pressures such as global financial instability, inflation concerns, or economic slowdown?
While the initial rise in banks’ investment in government securities around 2022 could be attributed to a gradual rise of bond yields to 7.53 per cent, the recent drop in the yields over the last few quarters have not translated into private banks changing the composition of their investment portfolio. These investments enhance financial stability of the banks during market disruptions, at the cost of limiting credit availability for businesses and consumers, potentially slowing economic growth if capital is not directed towards more productive sectors.
Moral suasion hypothesis
The rising exposure to government securities could also be a result of the so-called moral suasion hypothesis, when governments nudge banks to buy domestic sovereign debt securities. With the Government’s extensive plans of large-scale capital expenditure, this could be a strategy for financing of the public debt. On the other hand, capital adequacy constraints and sluggish profitability could push banks towards more risk-free investments. Thus, the trend of banks investing more in government securities is driven by their flight towards safety and regulatory compliance, especially in uncertain market conditions.
As far as household investment pattern is concerned, their investment in government securities have increased at a CAGR of 17 per cent much faster than banks’ increase. But in recent times after the pandemic, their share of investments in government securities has been falling. Going by their absolute numbers, from ₹142 billion in 2015-16 and touching close to ₹180 billion during the pandemic year 2020-21, household investment in government securities dropped significantly to ₹84 billion in 2022-23.
This could be a result of dropping bond yields coupled with a growing risk appetite for assets with higher returns, amidst inflation concerns. As a result, household investments in the volatile share markets and mutual funds have risen, quite contrary to bank behaviour in the same period. Further, households have moved beyond the traditional method of mobilising their savings through bank deposits and their reliance on capital markets has increased.
Rise in demat accounts
The compounded annualised returns of Nifty50 for the past 10 years (since March 2014) have been hovering around 8.8 per cent, creating more room for interest among equity holders. The Economic Survey 2024-25 corroborates the rising household inclination towards investments in capital markets by pointing out that number of demat accounts has risen sharply by 33 per cent to 18.5 crore at the end of December 2024 on a YoY basis. This comprises 11.5 crore unique investors with demat accounts and 5.6 crore unique investors in mutual funds as on December 2024.
While households have chosen the risk-loving mode of investment profile (high risk-high return), banks have chosen the risk-averse mechanism (low risk-low returns), during the same period.
The cause of concern would be whether commercial banks in India should be majorly involved in financing the large public debt of the Government and meeting its expenditure targets. Given the RBI norm for banks to keep an investment fluctuation reserve as a buffer against portfolio volatility, what remains to be seen is how diversification of banks’ portfolio choice affects their future intermediation activities.
Poulomi is Postdoctoral Fellow, IIT Kanpur, and Himadri is Assistant Professor, IIM Lucknow