VIEW: WHERE DO BABY DEPOSITS COME FROM?

There is a new chicken-and-egg story that has become the talk of the town, at least in the financial circles. Coffee machine conversations, professional whatsapp groups and even pink paper columnists seem to be wrapping their heads around one innocuous sounding question -. “What came first, Deposits or Advances”? That emotions are running high on the issue is understandable.

After all, the issue was brought to the fore by none other than the Governor of the Reserve Bank of India, who made a reference, with a hint of concern, to the increasing flow of personal savings to the stock market, causing a deline in the growth of bank deposits. This seems to have flustered the composure of the market sentinels.

“Why try to talk down the one bright spot in the India story to make life easier for bankers?” seems to be the overwhelming sentiment of the market watchers. I see two recurring themes in their arguments: - 1) the act of giving advances itself creates new deposits, so the proposition: ‘for advances to grow, deposits should grow first’, is fallacious; and 2) the money that goes into the stock market stays within the banking system at all times, and hence such flows don’t impact the overall growth of bank deposits at a systemic level.

Let us examine these points one by one.

It is indeed unassailable that disbursement of advances by banks create new deposits in their wake. A personal loan availed by you will show up as extra balance in the savings account, a car loan will reflect as a new credit entry in the current account of the car dealer, boosting the overall deposits of the banking system in both cases, and so on. So at first glance it does look like banks can create money out of thin air, or can they?

There must be a catch somewhere, isn't it? Before getting into unraveling that riddle let us take a moment to look at what money is and what it does. Though money does many things, for our present discussion the following two are the most relevant - a) it stores value and thereby provides the holder with purchasing power; & b) it provides liquidity and enables the holder to meet/fulfill his financial obligations. There are considerable overlaps between these functions but they are not the same, as we will see in some time.

The money created through a loan provides purchasing power to the borrower but it does not create new liquidity either for the bank or in the banking system. As a result the new money (deposit) created through a loan will spell trouble for the bank concerned unless they have already kept aside enough liquid reserves to meet the demands against their newly “minted” deposits. Sounds a bit confusing? Ok, but please stay with me, I will try to make it clearer.

Nothing like an experiment to explain the fundamentals, so let me propose a thought experiment. Imagine a new country (call it Kailasa if you wish) with just two newly set-up commercial banks and a Central Clearing Bank. The central bank is yet to create their money and the citizens are still a few weeks away from their first pay cheque. But Bank A decides to kickstart the Kailasa economy straightaway by disbursing the first loan to buy, say, a cow.

Also assume the seller of the cow has helpfully opened her account with Bank B in anticipation of the payment. The first leg of the money creation goes smoothly enough, Bank A creates a loan and transfers the loan amount to the account of the borrower, creating a new deposit from thin air, as promised. But soon the trouble starts.

The borrower wants to transfer the money in his account to the seller’s account in Bank B so that he can get hold of his cow. But Bank A doesn't have any balance (real money) in their account with the central clearing bank without which the proposed transfer to Bank B will not happen. Nor do they have any cash in their vault (the reserve money created by the central bank) that they can hand over to the buyer so he can exchange it for the cow. In short, Bank A will end up with a liquidity crisis on their first attempt to create money!

In short, If Banks try to create money without first creating liquidity first, the system will crash in no time. And liquidity is created when people and firms make deposits the old fashioned way, out of their savings. In short, in a stable system deposit growth has to lead credit growth at all times, QED. But why does money from savings and borrowings behave in two different ways? It is because borrowings are nothing but front-ended purchasing power today against one’s future liquidity (assuming an intention to repay).

So while the money is created at the time of disbursal of the loan, the corresponding liquidity will come to the system later, as the loan gets repaid. Since loans create money sans liquidity, the banking system can give loans only against pre-existing liquidity built up from real savings. (We can argue that banks can lend from their capital, but capital is also earnings accrued over the years). Interestingly, such a liquidity dichotomy is not created by government borrowings because when the Government borrows money, the central bank creates equivalent liquidity by ‘printing’ new reserve money.

Now let us look at the second question on the relationship between investment flows to the secondary market and bank deposits. Such flows represent savings and they do create deposits as well as liquidity in the banking system. But the problem is, such deposits move in eddies within a small circuit comprising various market participants, so instead of getting stable deposits banks get volatile balances in current and savings accounts that keeps gyrating every day. Even if a Bank has the daring to lend against such volatile funds, RBI's liquidity coverage norms will stop them from walking that path; so such ‘hot’ funds will mostly end up in government bonds or liquid mutual funds.

We have seen that a robust deposit portfolio is a necessary condition for credit growth, but is that the only condition? In other words, can the government accelerate credit growth by curbing the flow of savings to the capital market?

The answer is a resounding NO. . Such a move may improve the deposits portfolio and liquidity profile of the banking system, but for credit off-take to happen the investment climate and sentiment should change. Mere availability of credit will not entice companies to make new capital investment decisions or people to buy new homes. So the demand deficiency has to be addressed first. As for retail investors, one cannot blame them for putting all the eggs in one basket when that is the only basket that seems to be holding any promise at the moment.