VIEW: Easy to call banks lazy, but one needs to ask why aren't they lending

This may be a good time to ask some basic questions all over again.

Let’s start with liquidity and lending. The RBI Governor yesterday reminded us that banks are currently sitting on large amounts of surplus funds. What are these surpluses, and why aren’t banks lending them out to their clients?

The banking “surplus liquidity” — Rs 6.9 lakh crore as on April 15 - is the extra balance that banks have in their Cash Reserve Ratio (CRR) accounts with the RBI at the start of the day, over and above statutory requirements. Since CRR balances (3 percent of a bank's deposits)  earn no interest, banks today deploy these surpluses with the RBI at the Liquidity Adjustment Facility (LAF) window and earn the reverse repo rate.

The banking system cannot “lend away” these surpluses.

Every loan given out by any bank lands up in a client banking account within the banking system. Loans create client deposits and balances. In that sense, across the banking system, no funding is needed to give out loans. Strange as it might sound, loans are funded by the very deposits that they create, without directly impacting any surplus banking liquidity.

Lending does result in a very small secondary impact on banking liquidity surpluses. The deposits created by lending require CRR maintenance. To that extent, excess banking liquidity is marginally reduced. The quantum is quite small though. To increase CRR requirement (and hence reduce surplus banking liquidity) by say Rs 3 lakh crores, banks would have to make Rs 100 lakh crores worth of net fresh loans — or effectively double their current loan book.

Besides the slow drag of lending, what else can reduce banking surplus liquidity?

Withdrawal of currency notes by depositors, or sale of foreign currency/ INR bonds by RBI to banks reduce surplus banking liquidity. None of these routes are really in the hands of bankers.

To say that banks are being “lazy” in dumping extra liquidity with the RBI rather than deploying them productively, therefore, is a harsh mischaracterization of banking. Bankers cannot really materially change the surplus liquidity hand that they are dealt – not by themselves.

At best, faced with consistent large banking liquidity surpluses, individual banks would be incentivized to try and minimize their own surplus liquidity, and procure assets such as bonds and loans instead — essentially, lend out more. This passing the surplus liquidity parcel within banks would, however, do very little to address the systemwide liquidity surplus.

Also read: How the banking system works and how money is created

Even if liquidity surpluses are not needed to create fresh loans, they should at least nudge banks to create more loans. So why isn’t that happening?

Those entities that banks are willing to lend to aren’t investing or borrowing enough. On the flip side, banks don’t trust the creditworthiness of those that are desperate for funds — from amongst select players in sectors such as NBFC, HFC, MFI, real estate, telecom, airline & shipping etc. In addition, bankers are also riddled with the fear of making a wrong credit call, and then being tarred and feathered for the rest of their lives.

Trying to address this fear and mistrust with liquidity and lower interest rates is trying to address a brain tumor by applying ointment on our little toe.

Eventually, we need someone to absorb the bad assets in the financial services ecosystem, and someone to provide comfort that they will absorb losses against fresh loans made to MSME and stressed sectors.

That someone likely has to be the Government of India (GOI).

The provision of surplus banking liquidity does not solve any funding issue that comes in the way of banks making loans, because there is no funding issue to start with.

Instead, fear and trust deficit currently inhibit credit growth. Trying to address these with liquidity and lower interest rates is both the wrong diagnosis and the wrong medicine.

We instead need another doctor — the Government of India — to provide the cure here.