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📰India’s Banks Need to Do Some Self-Reflection, Says RBI

We analyze how Indian banks need to meet the moment by improving liability management.

February 21, 2025

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Welcome to the best way to stay up-to-date on India’s financial markets. Today, we analyze how Indian banks need to meet the moment by improving liability management.

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Market Update.

The RBI Thinks India’s Banks Need to Do Some Self-Reflection

Problem: India’s banks are struggling with a growing liability problem—essentially, they’re running out of good ways to fund their loans. RBI Deputy Governor Rajeshwar Rao just sounded the alarm, warning that poor liability management is leading to a rise in bad loans, choking profits, and making lending riskier.

Why this problem matters: When banks can’t lend, businesses can’t grow, jobs disappear, and the economy slows down. 

How we got here: The core function of banking revolves around accepting short-term deposits and providing long-term loans, a process known as maturity transformation. While essential to financial intermediation, this also exposes banks to various risks. Historically, regulatory frameworks like Basel I and II focused primarily on the asset side of bank balance sheets, emphasizing credit risk management and capital adequacy. The assumption was that credit defaults and asset deterioration posed the greatest threats to solvency, while liquidity and funding risks—mainly tied to liabilities—were considered manageable without stringent oversight.

The ‘08 Global Financial Crisis changed this perception. It revealed that even well-capitalized banks could face insolvency due to liquidity shortfalls, highlighting the fragility of funding structures reliant on short-term liabilities. In response, global regulations incorporated liquidity-focused measures, such as the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR), to enhance short- and medium-term liquidity resilience.

Liability management is critical for a bank’s solvency and profitability. The Net Interest Margin (NIM)—the spread between interest earned on loans and the cost of funds—is directly shaped by liability structures. Factors like the proportion of Current and Savings Account (CASA) deposits, the mix of retail versus wholesale funding, and liability durations significantly impact funding costs.

For instance, in India, deposits remain the primary funding source for Scheduled Commercial Banks (SCBs), making up 77 percent of total liabilities as of FY 2024. While term deposits have declined, the rise in CASA deposits has helped boost NIMs from 2.6 percent in FY 2015-16 to 3.3 percent in FY 2023-24. However, banks have also increased reliance on short-term funding instruments like Certificates of Deposit (CDs), raising concerns about potential risks if market conditions deteriorate.

Trends shaping liability management in India’s banking sector:

  • Household savings are shifting toward capital market assets like mutual funds and equities. This transition, driven by digital infrastructure, changing demographics, and higher equity market returns, may impact the composition and cost of bank deposits.

  • Banks are seeing a move from retail to institutional deposits, increasing funding costs. Retail deposits see far lower interest rates than the ones offered to large institutional accounts which increases liability costs. This could pressure banks to either raise loan interest rates — potentially slowing credit growth — or lower underwriting standards, increasing risk exposure.

  • Greater reliance on short-term funding instruments like CDs exposes banks to rollover risks (issues with refinancing or new borrowing when current debt, like CDs, mature), particularly during market stress.

Beyond banks, liability concerns extend to Non-Banking Financial Companies (NBFCs), which rely heavily on market-driven funding. Borrowings constitute 68 percent of their liabilities, making them more sensitive to interest rate fluctuations than banks. Over-reliance on short-term funding for long-duration assets can trigger liquidity crises, weaken investor confidence, and lead to credit rating downgrades.

RBI makes moves. To keep banks stable, the RBI has made it harder for NBFCs (non-bank lenders) to rely too much on bank funding. In response, NBFCs are turning to other ways to raise money, like Commercial Papers (CPs) and Non-Convertible Debentures (NCDs). Some are even borrowing from international markets, but that brings currency risks, which they have to hedge against.

The government is also tweaking its borrowing strategy. When banks buy government bonds, it can drain liquidity from the system, making lending harder. To ease this, the RBI uses open-market operations—buying and selling securities—to inject cash into the system and prevent bad loans from piling up.

Banks have their own tools to manage risk too. The Liquidity Adjustment Facility (LAF) lets them borrow short-term cash when needed, while the Standing Deposit Facility (SDF) helps them earn interest on extra money.

Effective liability management is no longer just about maintaining profitability—it is crucial for systemic stability. As the financial landscape evolves due to technological advancements, regulatory changes, and shifting consumer behavior, banks and NBFCs must adopt dynamic and comprehensive Asset-Liability Management strategies.

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Written by Yash Tibrewal. Edited by Shreyas Sinha.

Disclaimer: This is not financial advice or recommendation for any investment. The Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice.