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Impact Of Demonetisation On Liquidity, Capital And Credit In Indian Banking

A large part of this success is predicated on the relative return on liquidity and the ability of the financial markets to offer diversified liquidity deployment options

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Demonetisation of two high value currency notes sent ripples across the financial system and put banks at the centre of the action. Branches that have typically seen dwindling footfalls due to increased use of digital channels were flooded with customers seeking to either deposit or exchange notes. While the flood of customers into branches impacted banking operations temporarily, sustained impact is likely to be seen on the balance sheet structure and liquidity position of banks. The additional liquidity absorbed by the banking system due to demonetization is also expected to have varying impacts on the marginal cost of funds based lending rate (‘MCLR’). While largely retail focussed banks have seen increase in low cost liquidity, wholesale focussed banks have seen proportionately lower increase in low cost liquidity. Commensurately, wholesale banks are likely to see increased pressure on margins as wholesale customers look for re-financing options as largely retail oriented banks are able to translate low cost liquidity into lower MCLR. Inspite of lower MCLR, growth in credit off-take continues to be slow due to both macro factors and regulatory capital constraints of banks. This has created an interesting challenge for banks as they seek to balance the equation between return of excess liquidity, overall net interest margins and return on equity.

Walking the liquidity and net interest margin tightrope
The December quarter saw the CASA ratio of banks increase between 5% and 10%. With this additional liquidity and muted credit off-take, bank treasuries were faced with the task of deploying this liquidity while maintaining the market, credit and liquidity risk profile of the bank. Excess liquidity also put pressure on yields in debt markets. Temporary measures to prevent the liquidity flow impacting bond markets through temporary increase in the cash reserve ratio helped stabilize bond yields. However, these measures coupled with lower yield on liquidity not deployed in credit assets are expected to continue to pressure the net interest margins (‘NIM’) of banks. One of the biggest challenges for bank treasuries in the coming months will be to find the right assets in debt markets to reduce impact on NIMs. Future cuts in policy rates will continue to impact overall NIMs of banks until increase in relatively higher yielding credit off-take off-sets the impact on margins caused by lower yielding treasury deployments in money market and short-term debt instruments.

Managing the credit and capital conundrum

While excess liquidity creates lending capacity, shortage in regulatory capital leads to credit rationing. In the current regulatory capital regime largely based on standardized approaches, credit risk capital is a function of ratings, collateral and at times industry-segment of the borrower. Borrower specific attributes and risk profile are not always factored into ratings and industry risk assessments. This can lead to non-collinearity between the real risk profile and the associated regulatory credit risk capital mandated for the lending. This phenomena is likely to be more pronounced in the non-collateralised retail lending segment. The excess liquidity coupled with sometimes misaligned credit risk capital requirements can create a case for lowering the lending quality. For an industry still reeling from non-performing assets, managing credit quality in the coming months is likely to be very critical.

Sustaining the liquidity
While demonetization has brought liquidity into the financial system, sustaining the liquidity is a different challenge. As the dust settles on demonetization, the liquidity is likely to seek higher returns. Keeping liquidity in the financial system will depend on the ability of banks to offer attractive longer term deposit rates, engage customers with third party investment products and enable ease of fund flow within the financial system. If the excess liquidity cannot be dispersed across the banking system, bond markets and to some extent money markets, liquidity is likely to find its way back out of the financial system.

Demonetisation has the potential of providing a long-term fillip to the financial system as savings move towards funding economic investments as opposed to non-generating assets. A large part of this success is predicated on the relative return on liquidity and the ability of the financial markets to offer diversified liquidity deployment options.

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.

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Demonetisation banking liquidity

Ram Iyer

The author is Director, Deloitte Touche Tohmatsu India LLP

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Muzammil Patel

The author is a Partner, Deloitte Touche Tohmatsu India LLP

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