Declining Liquidity Coverage Ratios To Slowdown Banks' Credit Growth

In its recent report, the rating Icra has highlighted that the share of deposits from retail customers and small businesses declined by almost 4.8 per cent since its peak in June 2021 to 59.5 per cent of total deposits by March 2024. This reflects a relatively higher growth in wholesale deposits for banks compared to retail deposits. 

Since such wholesale deposits have higher run-off factors, a larger share of such deposits adversely impacts banks' reported liquidity coverage ratio (LCR). A decline in LCR would need banks to place a higher share of their incremental deposits towards high-quality liquid assets (HQLA) instead of deploying these deposits for credit growth.

Additionally, the proposed changes by the Reserve Bank of India (RBI) in its draft circular dated 25 July 2024 to review the LCR guidelines will reduce the system-wide reported LCR by 14 to 17 per cent, i.e., from 130 per cent reported during Q4 FY2024 to 113-116 per cent, on account of the higher run-off factors for certain deposits and haircuts on the HQLA. Banks would then need to rework their strategy on credit and deposit growth, especially where the LCR declines to a level closer to the regulatory requirement of 100 per cent. 

To recoup the LCR loss, banks may focus more on retail deposits, reducing the share of wholesale deposits, moderating credit growth and deploying a higher share of deposits to the HQLA.

Sachin Sachdeva, Vice President and Sector Head– Financial Sector Ratings, Icra said, “With the declining share of retail and small business deposits of banks, Icra expects the interest rate on retail deposits to remain elevated even if the credit growth slows down. The peak deposit rates for banks, hence, may stay elevated despite expected rate cuts in H2 FY2025, implying delayed transmission. In such a scenario, the banks may cut down low-yielding wholesale exposures, who will then have to shift to the debt capital markets or external commercial borrowings.”

As per Icra's assessment, the recent regulatory actions like urging banks to reduce their credit-to-deposit (CD) ratio, increasing risk weights towards high-growing loan segments, and the proposal to review the LCR framework, all point to the need to align credit growth with deposit growth while focusing on growing retail deposits. ICRA expects the non-food bank credit (NFBC) growth to slowdown to Rs. 19.0-20.5 trillion (11.6-12.5  per cent YoY) in FY2025 from Rs. 22.3 trillion (16.3 per cent YoY) in FY20241.

The rating agency added that the incremental deposit growth is expected to moderate to Rs. 19.4 to 20.0 trillion (9.5 to 9.8 per cent YoY) in FY20251 from Rs. 23.2 trillion (12.9 per cent YoY) in FY20241.

With credit growth outpacing deposit growth, the CD ratio reached an all-time high of 78.0 per cent (80.2 per cent including the impact of the HDFC merger) as of March 2024 in the last five years. Thereafter, following the regulatory nudge to banks to moderate their CD ratio, there has been a slight dip to 77.1 per cent as of June 2024 with incremental CD ratio declining to 60  per cent in Q1 FY2025.

Overall, Icra anticipates that banks will moderate their credit growth targets in the run-up to the proposed implementation of revised LCR norms concerning 01 April 2025, resulting in an improvement (i.e., decline) in the CD ratio and an increase in liquidity buffers. ICRA views these as positive developments from the banks’ risk perspective, however, at the same time the negative impact on return on asset (RoA) and return on equity (RoE) can be 6-7 basis points (bps) and 70 to 90 bps, respectively.

“With lower growth aspirations, banks can be selective with the lending segments they choose to grow, for improved pricing power. To neutralise the impact on profitability because of the proposed LCR guidelines, banks will need to hike their lending rates by 10 bps. This could mean a higher cost for the borrowers,” Sachdeva added.