Reliance on borrowed funds risks banks’ health: RBI

 HIGHER reliance on borrowed funds rather than deposits to finance businesses poses a threat of systemic risk to banks, according to the Reserve Bank of India (RBI). 

    The central bank, in its July policy review had already indicated that it would be initiating inquiries against banks with very high creditto-deposit ratios. 
    According to the latest report on currency and finance released by RBI last week, deposits, traditionally, constituted the primary source of funds for banks. But they started relying on borrowings, as depositors switched to other alternate instruments such as mutual funds and stocks as the financial market developed. 
    The report says, "In this new environment, banks face the challenge of proper assessment of risks associated with borrowed liquidity against stored liquidity inherent in core deposits. Regulators also need to be proactive in dealing with the emergence of any systemic risks." 
    As deposits are generally insured up to a threshold limit by the government, they allow savers to retrieve their funds on demand without any capital loss, thereby ensuring full safety. 
    For banks, insured deposits are not only a subsidised source of funds with no default risk, but also constitute the preferred 'core' funding for banks. 
    But borrowings are considered to be more sensitive to a bank's financial health. As the providers of uninsured funds risk losing their money in case of a bank failure, they are more likely to demand higher returns or pull out some of their money from the bank. 
    The report has cautioned that this shift in resource mobilisation by banks has several implications for resource management. First, the decline in cheaper insured deposits may raise the costs for banks by making them rely on more expensive funding through borrowings. Therefore, the shift to non-deposit funding would require banks to engage in more active, complex and costly management of their funding base to ensure that they can meet their repayment commitments. 
    Second, in certain circumstances, raising funds through non-deposit sources such as borrowing or bulk deposits may be cheaper at the margin than the insured deposits even if the rates paid on non-deposit funds are actually higher. 
    This could be due to higher noninterest costs required to raise insured deposits such as the expense of branches, staff and technology. 
    Further, the report has said that while raising rates to attract new deposits could also increase the cost of its existing deposit base, borrowings can be raised by banks without altering the cost for its existing deposits. Therefore, banks, in the face of growing preferences towards nondeposit instruments, may find it economical to reduce their branch structure or to carry out new techniques for raising money. 
    However, with increasing reliance on non-deposit sources of funding, banks would have to develop the requisite expertise to design prompt and cost-effective repayment schedules, establish additional sources of emergency back-up funds, and build up buffer of marketable and liquid securities.

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