Skewed Credit-To-Deposit Ratio And The Art Of Creating Money Out Of Thin Air

Two major concerns have dominated India's banking sector over the past two years: rising unsecured loans and slow deposit growth. A common thread linking both is the regulatory intervention, which has pressured banks’ net interest margins.

The Reserve Bank of India tightened rules in November 2023, making it costlier for banks to issue high-margin uncollateralised loans such as personal loans and credit cards.

It also nudged banks to slow lending, citing concerns that an elevated credit-to-deposit ratio could pose liquidity risks and threaten financial stability. The credit-to-deposit ratio has hovered around 80% since September 2023. On an incremental basis, this ratio crossed 100% in 2022-2023 and 2023-2024. While the RBI has not prescribed a specific threshold, it was certainly uncomfortable with these figures. RBI Shaktikanta Das, who demitted RBI Governor’s office in December, had advocated maintaining a correlation between credit and deposits to prevent unnecessary exuberance. 

Between March 2022 and November 2024, loan growth consistently outpaced deposits, with the gap exceeding 700 basis points at one point. While the gap has since converged, the overall credit-to-deposit ratio remains stubbornly high at 80%.

The credit-to-deposit ratio is made up of two variables: loans and deposits. Since deposits are hard to come by, the regulatory focus has shifted towards curbing loan growth. However, this is easier said than done, as restricting credit could hurt economic expansion, especially when the GDP growth outlook is already sombre. Credit growth and nominal GDP growth have a strong correlation. According to economists at the Bank of Baroda, over the past 12 years, India’s average nominal GDP growth stood at 11.1%, while bank credit growth averaged 11.7%.

But why is deposit growth struggling? Several explanations have been offered.

One is a shift towards higher-yielding investments such as mutual funds and stocks. Moreover, some consumers avoid going to banks due to concerns about financial products being mis-sold. While these factors seem convincing, they don’t fully explain the issue. Regardless of whether money is invested in stocks or bonds, it remains within the banking system. Transfers between investors and sellers still result in deposits at a system-wide level. Yes, the composition of the money changes. Retail deposits may be shrinking, but wholesale deposits held by fund houses are rising.

Deposit Churn

So what’s really happening? It turns out banks don't necessarily need fresh deposits to issue loans. In fact, it works the other way around.

Let's assume ABC Bank grants a ₹1 million home loan to Mr X. Instead of drawing from an existing deposit pool, the bank simply makes an accounting entry of the loan by crediting Mr X’s account. In doing so, ABC Bank has effectively created a fresh deposit. This process shows how banks expand the money supply through lending.

Why, then, do banks need fresh deposits? Because their ability to continue lending depends on capital reserves and regulatory constraints. They need to maintain adequate liabilities to balance their loan books. Plus, the RBI is concerned about higher credit-to-deposit ratios.

Ultimately, the ability of banks to create deposits out of thin air depends on the RBI. The central bank controls reserve money—a liability on its balance sheet—through various mechanisms such as open market operations or foreign exchange interventions. Essentially, aggregate deposits in the banking system are created by the RBI, and subsequent credit extension functions as a money multiplier.

However, in recent years, the RBI’s money creation has been rather slow.

Calculations by Nomura analysts show that net money creation by the central bank was only ₹600 billion in 2023-2024, compared with approximately ₹6–7 trillion on average between 2019 and 2023.

This slowdown coincided with the RBI's tight monetary policy stance (which the central bank termed ‘withdrawal of accommodation’) aimed at curbing inflation. A more accommodative monetary policy would have risked driving up prices even higher.

The good news is that the RBI has already shifted its monetary policy stance to neutral. Recently, it announced measures to inject around ₹1.5 trillion of liquidity in a phased manner to address the banking system’s peak deficit of ₹3.15 trillion. Hopefully, this will help solve the challenge of slow deposit growth without curtailing loan growth.