Costly deposits to affect banks' profitability: Icra

ANALYSTS' VIEW

The common argument offered is that high-cost deposits enable banks to earn a positive interest spread, even if only a thin one, against short-term assets.

However, the point to note is whether the thin interest spread earned covers all associated visible and invisible costs (the costs arising from the regulatory prescription requiring banks to park a substantial portion of their deposits in risk-free instruments, which offer low yields). If it does not, such lending would erode a bank's earnings.

Another often-stated argument is that high-cost deposits are raised for funding of higher-yielding personal loans or credit card receivables; the interest spreads are therefore adequate. This approach often leads to sub-optimal allocation of resources.

This is so because the incremental business may well have been funded through the liquidation of low-earning assets rather than via incremental deposit mobilisation. Thus, this argument disguises the impact of high-cost deposits on earnings.

Raising high-cost deposits enables a bank to gain a larger share of the loan market and acquire customers for loans at floating rates of interest to increase the interest rates subsequently to improve interest spreads. It also helps build customer relationships and allows a bank to fund loans until low-cost deposits build up.

However, a business strategy that envisages recourse to high-cost deposits to fund growth can well provide long-term value, provided the earnings over a longer horizon are adequate to cover costs.

If high-cost deposits are mobilised merely to show an increase in market share and/or to fund assets with unsustainably low interest spreads, then the strategy is bound to affect banks' longer-term profitability.