Prof D Mukherjee
mukhopadhyay.dinabandhu@gmail.com
In the closing quarter of India’s financial year (Q4 FY 2025-26), the banking system is grappling with a structural imbalance that has gradually evolved into a macro-financial concern: credit expansion continues to outpace deposit mobilisation. Recent data published by the Reserve Bank of India indicates that non-food bank credit has been growing at approximately 14-16 percent year-on-year, while aggregate deposits have increased at a slower pace of around 10-12 percent. This divergence, evident since FY 2023-24, has narrowed liquidity buffers and heightened systemic dependence on short-term funding. The divergence reflects strong retail credit demand driven by housing, personal consumption, and MSME financing, alongside sustained public investment-led growth. In contrast, deposit growth has softened as households increasingly allocate financial savings to market-linked instruments such as mutual funds, insurance products, and small savings schemes. Industry estimates show mutual fund assets surpassing ?50 lakh crore in 2025, underscoring a shift in household financial preferences away from traditional bank deposits. Although banks remain compliant with Liquidity Coverage Ratio requirements, surplus liquidity cushions have eroded. Institutions are increasingly relying on wholesale funding instruments and certificates of deposit to bridge the funding gap. The year-end quarter compounds pressures due to advance tax outflows, seasonal currency leakage, and balance sheet adjustments. Should this divergence persist, funding costs may rise, lending conditions may tighten, and monetary policy transmission may weaken. The present imbalance underscores the urgent need for synchronised deposit mobilisation and prudent credit expansion to maintain systemic liquidity stability.
A sound banking system depends on a stable and expanding deposit base that grows in tandem with credit demand. Deposits represent the most reliable and cost-effective funding source for banks, underpinning financial intermediation and supporting liquidity resilience. When credit growth persistently exceeds deposit mobilisation, banks are compelled to seek alternative funding through wholesale markets and short-term borrowing instruments, which carry higher costs and greater volatility. Recent data show that the incremental credit-deposit ratio of scheduled commercial banks has risen above 80 percent, exceeding the comfort range of 70-75 percent. A sustained elevation of this ratio signals mounting funding stress and increased vulnerability to liquidity shocks. Robust deposit growth ensures stability by providing a dependable funding base, preserving low funding costs, strengthening liquidity buffers, and enabling efficient transmission of credit to the economy. Beyond banking stability, deposit mobilisation reflects household confidence and supports domestic resource mobilisation-an essential pillar in a developing economy where bank lending finances infrastructure, small businesses, and consumption. If deposit growth continues to lag, banks may respond by tightening credit standards or raising lending rates to protect margins, potentially dampening economic momentum. Maintaining equilibrium between deposit and credit growth is therefore not merely an operational objective but a macro-financial imperative.
The sustained lag between deposit mobilisation and credit demand has far-reaching implications for financial stability and economic performance. Funding shortages compel banks to attract bulk deposits or rely on market instruments such as certificates of deposit and interbank borrowings. These sources carry higher interest costs, compressing net interest margins and prompting banks to raise term deposit rates. Since 2022, term deposit rates have increased by roughly 150-250 basis points as institutions compete for funds.
Open Market Operations (OMOs) are a principal tool through which central banks inject liquidity into the financial system by purchasing government securities. However, aggressive liquidity injections often fail to provide durable relief when underlying structural imbalances remain unresolved. Liquidity infusions cannot substitute for stable deposit funding, particularly when household savings continue migrating toward capital market instruments. Furthermore, liquidity injected through OMOs may be offset by sterilisation effects arising from large government cash balances and tax outflows that absorb liquidity from the banking system. When credit demand structurally outpaces deposit growth, central bank liquidity support becomes transitory rather than transformative. External factors also play a role; elevated global interest rates and capital flow volatility can tighten domestic liquidity conditions despite central bank interventions. Several macroeconomic policy variables exacerbate the situation. Persistent fiscal deficits can crowd out private liquidity, while elevated inflation discourages financial savings in bank deposits. Interest rate misalignment reduces the attractiveness of deposits, and high returns on small savings schemes divert household funds away from the banking system. Inefficient financial savings incentives further encourage households to seek higher-yield alternatives. Without coordination between fiscal, monetary, and savings policies, OMOs function merely as temporary palliatives rather than systemic solutions.
Addressing liquidity stress in the money market requires coordinated macroeconomic responses that strengthen the deposit base and improve liquidity management. Enhancing the attractiveness of bank deposits is essential, including rationalising taxation on deposit interest and introducing inflation-indexed deposit instruments that preserve real returns. Expanding digital savings platforms can also deepen financial inclusion and broaden the deposit base. Improved liquidity forecasting and closer coordination between government treasury operations and the central bank can help smooth liquidity fluctuations arising from uneven expenditure patterns and tax flows. Strengthening financial savings mobilisation through pension-linked and long-term deposit schemes can encourage households to maintain stable savings within the banking system. Financial literacy initiatives can further support balanced savings behaviour. Ensuring real positive returns on deposits remains critical to sustaining household savings. At the same time, deepening repo markets and improving secondary market liquidity in government securities can enhance money market efficiency. Safeguarding external liquidity through adequate foreign exchange reserves and macroprudential tools will further help stabilise capital flows and domestic liquidity conditions. Such coordinated measures can restore equilibrium between liquidity supply and demand while strengthening systemic resilience.
As the financial year draws to a close, prompt government action can play a decisive role in preventing liquidity constraints from undermining economic performance. Accelerating the release of budgeted capital expenditure can inject liquidity into the financial system while simultaneously supporting growth and infrastructure development. Aligning small savings scheme rates with market conditions can prevent excessive diversion of funds away from the banking system. Encouraging public sector enterprises and government agencies to maintain operational balances within banks can support deposit flows and improve liquidity stability. Facilitating targeted refinance windows for MSMEs and priority sectors can ensure the continued flow of credit to critical segments of the economy. Speedier tax refunds can improve working capital availability for businesses, strengthening liquidity in productive sectors. Clear fiscal consolidation signals and prudent fiscal management can enhance investor confidence and reduce liquidity volatility. Expanding financial inclusion initiatives, including small deposit schemes and basic banking accounts, can broaden the deposit base and strengthen systemic resilience. Timely fiscal and administrative measures can therefore stabilise liquidity conditions and sustain growth momentum during the crucial year-end period.
The widening mismatch between deposit growth and credit demand represents a structural vulnerability within India’s banking system. With credit expanding in the mid-teens and deposits growing several percentage points slower, liquidity buffers are tightening and funding costs are rising. If left unaddressed, this imbalance could weaken Liquidity Coverage Ratios, elevate borrowing costs, constrain credit availability, and slow economic momentum. Central bank interventions, including liquidity injections, provide temporary relief but cannot substitute for stable deposit mobilisation. A durable solution requires coordinated fiscal discipline, calibrated monetary policy, and incentives that encourage households to maintain financial savings within the banking system. Strengthening deposit mobilisation through competitive returns and innovative savings products is essential. Aligning fiscal, monetary, and savings policies will support financial savings and improve liquidity stability. Enhancing liquidity forecasting, maintaining real positive deposit rates, rationalising small savings schemes, and deepening money markets will further reinforce financial resilience. Encouraging financial literacy and a culture of long-term savings can sustain deposit growth over time. A coordinated policy framework that restores balance between deposit mobilisation and credit expansion will safeguard liquidity stability, reinforce financial system resilience, and sustain economic growth as the financial year concludes.
(The Columnist is Chief Education Officer & Principal Secretary-Office of the Chairman, IIMSTC, Bangalore .)
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