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Effect of Demonetization in Banking Sector: A Game of Pros and Cons

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Effect of Demonetization in Banking Sector: A Game of Pros and Cons

At the sundown of November 8, 2016, the Prime Minister of India, Mr. Narendra Modi had brought the country into surprise by declaring that the INR 500 and INR 1000 will no longer be a legal tender from midnight. The RBI termed it as a ‘bold’ move in the battle against corruption and black money. New chip based INR 500 and INR 2000 notes were to be circulated by November 10, 2016. Controversy, opinion, debate flooded regarding the policy. According to the Ministry of Finance, during 2011-2016, the growth of circulation of all notes was 40% whereas the circulation of the targeted denominations went up by 109%, which is a contradictory number and hence the sudden policy imposition.

Well, this move will definitely eliminate the prevailing stock of fake currency to quite an extent in the long-run, but, its impact and repercussions will resonate across sectors with varying concentrations.  This blog concentrates on the impact of demonetization on banking sector. Is the policy turning out to be positive or negative for the banks?

As an instantaneous response to the policy, the banks observed extended queues were panic- stricken citizens flocked to deposit INR 500 and INR 1000 notes in exchange for lower denomination. The queues were observed in every bank branches, across the country. Though commercial banks had predicted the rush and prepared their outlets with enough cash and longer working hours, however it created uneasiness among people who figured out that the whole procedure demanded long wait along with unavailability of new notes.

On a brighter side, this ‘rush’ is an indicator to growing currency deposit in Current Accounts and Savings Account (CASA) of commercial banks. This will further improve the liquidity locus of the banks, which can be exploited later on for lending purposes. The improved CASA will automatically diminish the dependency of banks on high cost borrowing. Let us assume around INR 15 trillion of the targated currencies are in circulation in the market, of which 50% gets deposited. This will add to the CASA deposit by INR 7.5 trillion. This count is 9 % of the deposit base. In such a situation, banks will lower the funding cost and transfer the benefits as lending rate cuts.  Therefore, CASA improvement will remain positive for short run and long run. This is majorly due to upsurge in money multiplier in the country and increased deposit multiplier for banks.

As per the SBI Chairman Arundhati Bhattacharya, “All rates will fall. The bank has seen huge inflow of deposits but demand for credit has slowed down. Therefore, lending rates too will fall but after a gap.

Keeping the statement in mind, with ample liquid funds, banks will cut down their deposit rates. Already ICICI, Canara, HDFC Bank have slashed their fixed deposit rates by 1%. Similarly, State Bank of India has slashed their fixed deposit interest rates by 0.15%. In such a scenario, this will automatically lead to a cut in the lending rates. Thus, this calls for a lower EMI in future.

On the contrary, these reduced fixed deposit rates will create a strong competitor for the banks, which is the market for mutual funds. People will prefer to keep their money in mutual funds to receive more returns. Quite a number of mutual funds have given 2% return over the week. With stock prices crashing due to demonetization, there is a high possibility that citizens will invest in equity mutual funds at a lower rate and reap its profit in the long run.

Now, the condition for Non-Performing Assets (NPA) in banks will get hit the most. As an immediate outcome, sectors with high cash flow will be much affected, this includes the real estate and unorganized service sector.  With the dearth of liquidity in these sectors, NPA and working capital credit is to shoot up drastically.  Agriculture loan will also contribute to NPA. However, the extent to which the ongoing NPAs will be covered is worth watching out for.

Finally, with reduction in cash transactions, alternate mode of payments have risen. Banks should have a strong infrastructure to meet the growing demands of plastic money, E-banking and other digital transacting methods. Already certain banks are installing POS machines vigorously and extended the debit card limits to tackle the situation.

Nevertheless, remain vigilant and monitor the news and other media sources to keep abreast of the latest developments related to this policy for leveraging the maximum benefit arising out of it.

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