Banks and financial institutions form the lifeblood of a nation’s economy. A modern economy cannot survive without these institutions. They mobilize resources in the form of savings and make those resources productive in the form of loans and advances. Banks and financial institutions are conservatively subjective when it comes to assessing the risks as they are the most aggressive users of leverage. They accept deposits from the clients in excess of their core capital by many fold and use these deposits for earning interest, the cardinal source of income . It is to be noted that when investing in projects, banks ought not only to consider the profits to be made, but also the safety of depositors’ funds. They should also consider whether credit risks are survivable and comply with the policies of the central bank.
Banks need to balance the interests of depositors, the objectives of shareholders, and the needs and expectations of the borrowers. Recently, the high liquidity in banking has posed considerable challenges for banks in managing these competing factors. If deposit interest rates remain unchanged, the rise in liquidity can lead to increase in costs, compromising the profitability of banks. On the other hand, reducing interest rates might affect depositors and could result in capital flights.
Recently, depositors from cooperatives have started returning to banks. Previously, they were attracted to cooperatives due to higher interest rates. However, as most of the cooperatives are found problematic, they have returned to banks. This trend shows that depositors are looking for both the safety of their deposits and a fair interest rate as well. Consequently, if banks do not offer sufficient returns, there will be a risk of losing capital.
Utilize excess liquidity to revive the economy
Increasing liquidity puts pressure on banks’ profits. It isn't always practical to reduce interest rates, although liquidity can rise to some degree. Banks are required to follow the regulations of the central bank, but they also have to offer depositors interest rates that at least keep pace with inflation. Nevertheless, as liquidity keeps climbing, there's a chance that interest rates might dip into negative rates. If that happens, the country might encounter even more significant economic challenges.
The central bank plays a crucial role in regulating interest rates. When interest rates in the financial sector are low, the central bank tends to accept deposits through auctions. Conversely, when rates rise, it works to maintain them within a target band by injecting liquidity into banks. However, with banks experiencing higher liquidity, the central bank has found itself in need of open market operations more frequently than before. In the current situation, this approach has also become quite difficult for the central bank.
In the month of Kartik, the interest rates on deposits as well as on loans dropped. Theoretically, there should be a boost in loan investment with the decrease in interest rate. Unfortunately, the theory is not applicable in the economy. An excess amount of liquidity which is more than Rs 100 billion has been idle in the banking channels due to growing remittance and low demand for loans. Even though the “ease monetary” policy was launched, this has not produced positive impacts in the market. Therefore, the excess liquidity is quite worrisome in terms of the overall health of the economy. In any case, it appears that the government's capital expenditure is slow and contract amounts are not disbursed regularly. Conversely, even with political instability and an anti-investment environment, the excess liquidity of the banking sector has not been transferred to the productive sector.
While preparing policies, the central bank has to also look at the overall stability of their depositors, the government, the borrowers and the entire financial sector. As its instructions will impact processes in the banking sector, the industry, business and economic activity as well as the capital market and the Government, there should be a focus on the stability of the money market, banking and other financial institutions together with the growth of the economy. It is important to understand that in seeking to achieve stability in one area, there will always be an “equivalent exchange” of instability of some sort in other areas.
If we look at the data, the government and central bank have set an ambitious target of achieving a 6% economic growth rate in the fiscal year 2081/82. To accomplish this goal, the central bank aimed for a 12.5% increase in private sector’s credit. However, as we move into the second month of the year, loans from banks and financial institutions to the private sector have only risen by 1.4%. When viewed on an annual basis, this results in a modest growth rate of 6.6%. This slow credit growth is concerning, as it falls well short of the expectations established by policymakers. But, the rate of deposit growth is considerably outpacing the credit growth rate. This difference is a crucial factor contributing to the increase in liquidity. As liquidity grows, banks are pressured to lower interest rates in order to cut costs.
In the current economic situation, the projected increase in loan flow due to declining interest rates has not materialized, as demand for the product in business sectors remains inadequate. Despite the central bank's efforts to facilitate easier monetary policy, this approach has not generated the expected results. Contributing factors include a challenging investment climate, slow growth of government capital expenditure, heavy dependence on imports for consumption, and the central bank's working capital loans guideline, all of which have resulted in a significant buildup of liquidity within banks.
In the upcoming days, it's crucial to promote remittances through official banking channels and to put a stop to shadow banking practices. We need to transform investment in the banking sector from consumption towards production. It's important to focus on attracting foreign investment, developing industries that cater to exports, and implementing strategies that encourage both import substitution and export growth. If we don't implement innovative strategic practices, lower interest rates won't positively affect the economy. Moreover, there should be an increase in government capital expenditure. While making these efforts, the central bank must stay alert to the risk of misuse of loans in unproductive sectors.
