The banking sector has been grappling with a significant capital shortfall over the past 1 to 2 years, which has created challenges for financial institutions. However, a substantial surplus has emerged in the banking system, amounting to approximately Rs 3.07 lakh crore as of mid-July. This surplus, while considerable, is not currently being utilised for immediate lending or investment activities. In response to this situation, the Reserve Bank of India (RBI) is employing the Variable Reverse Repo Rate (VRRR) as a strategy to effectively siphon off this excess liquidity.
On April 9, the RBI conducted an auction that successfully withdrew Rs 97,315 crore from the banking system, marking a significant step in its ongoing efforts. The central bank plans to remove the remaining surplus of around Rs 2 lakh crore soon, utilising the VRRR mechanism. The VRRR is an essential tool within the reverse repo framework, which is designed specifically to absorb surplus liquidity from the banking system. To clarify, the reverse repo rate is the interest rate at which the RBI borrows funds from commercial banks, operating as a counterbalance to the repo rate—the rate at which the RBI lends to banks, primarily aimed at controlling inflation and stimulating credit growth.
In recent months, factors such as reduced withdrawals for tax payments and a surge in government expenditures have contributed to this increase in liquidity within the banking system. The outlook suggests that this liquidity surplus may persist, particularly as the cash reserve ratio (CRR) for banks is set to be lowered by 100 basis points in incremental phases of 25 basis points each, projected for completion by December. Analysts estimate that this reduction in CRR could elevate the liquidity levels in the banking system to exceed Rs 5 lakh crore by the end of the year.
It’s noteworthy that commercial banks have been facing a notable decline in capital availability over the past couple of years. This downturn can be attributed to traditional investors—who have historically relied on banks for savings—shifting their investments toward alternative assets such as stock markets, gold, and bonds. This trend has resulted in a significant decline in deposit levels within banks, which, in turn, is impacting overall credit growth.
Given this backdrop, one might wonder why there seems to be an apparent reluctance to take out loans despite the availability of ample cash in the banking system. The financial landscape reveals that in the fiscal year 2025, the nation’s gross domestic product (GDP) experienced growth at a modest rate of 6.5 per cent, marking the slowest growth trajectory since the COVID-19 pandemic onset. The RBI has projected a similar 6.5 per cent GDP growth rate for the current financial year. While this pace remains sluggish, it is important to recognise that the Indian economy continues to be one of the fastest-growing economies globally, highlighting its resilience and potential despite current challenges.
Considering the sluggish growth rate observed in the economy, the government is actively urging banks to bolster their lending activities. As part of this initiative, the central bank has implemented a substantial reduction in interest rates, slashing them by 100 basis points over a short timeframe. This move underscores the importance of passing these benefits onto customers to rejuvenate the nation’s growth trajectory.
However, despite these strategic efforts to stimulate borrowing, the loan growth rate has surprisingly dipped to 9.6 per cent for the fortnight ending June 13, a stark decrease from the robust 19.1 per cent recorded in the same period the previous year. Notably, the industrial sector has been particularly hard hit, with its loan growth plummeting from 9.4 per cent last year to just 4.8 per cent. The primary catalyst for this decline is a significant drop in loan originations for large industries, which have been experiencing lacklustre performance for several months now.
Following a series of reductions totalling 50 basis points in the repo rate between February and April, banks have proportionately lowered the interest rates on loans linked to external benchmarks. These loans constitute about 40 per cent of their balance sheets. The concomitant reduction in loan rates, alongside the eased cost of capital resulting from lower Cash Reserve Ratio (CRR) and repo rates, has brought the cost of borrowing down to align with current loan rates.
However, a prominent factor contributing to the stagnation in loan uptake is the elevated cost of capital for banks. Over the past year or two, banks have significantly raised interest rates on deposits to secure less expensive capital. Consequently, many banks find themselves in the position of reassessing their deposit rates in response.
It is important to note that even if banks initiate cuts to deposit rates, the effects may take some time to materialise. Thus, net interest margins could remain under considerable pressure, at least throughout the current financial year. To facilitate loan growth, several public sector banks have begun extending credit to Non-Banking Financial Companies (NBFCs), which are in urgent need of capital. Notably, data indicates that, as of May, bank credit extended to NBFCs has contracted by 0.3 per cent year-over-year, contrasting sharply with the 16 per cent growth observed the previous year.
In the prevailing economic climate, even the presence of low loan interest rates has not successfully spurred an increase in borrowing activity. Forecasts suggest that low interest rates are unlikely to lead to a noticeable uptick in loan uptake over the next 12 to 24 months. Banks are already accustomed to financial conditions characterised by low interest rates and significant liquidity surpluses; similar circumstances were prevalent following the global financial crisis of 2008, when both interest rates and the cash reserve ratio were substantially slashed. At that time, the government similarly encouraged banks to ramp up lending to stimulate GDP growth.
Following a sharp rebound in credit growth at the beginning of the last decade, the banking sector subsequently faced a surge in Non-Performing Assets (NPAs), which soared to 11.6 per cent of total loan allocations by March 2018. Although this situation improved over time, it planted a seed of caution among banks, leading them to adopt a more conservative approach when it comes to aggressive lending strategies aimed at accelerating loan growth. A reversal in the interest rate trend could result in a considerable number of loans transitioning into NPAs.
On a related note, industrial growth figures for February 2025 reflect a concerning trend, marking the slowest growth in six months at 2.9 per cent, down from 5 per cent in January. Similarly, the mining sector experienced a decline, with growth recorded at just 2.8 per cent, its lowest in four months. Earlier data indicated an industrial growth rate of 3.2 per cent in September 2024, with stagnation at zero per cent in August. This slowdown in industrial performance can be attributed to weaknesses within the manufacturing and mining sectors, which play a crucial role in driving industrial development, with the manufacturing sector alone accounting for over three-fourths of this growth.
In conclusion, it becomes evident that the lack of momentum in borrowing can be attributed to a confluence of factors, including the downturns in the manufacturing and mining sectors, subdued demand for credit, and a scarcity of affordable capital for banks, among others.
Satish Singh, Mumbai-based Senior Columnist, views are personal
