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“All animals are equal, but some are more equal than others.” George Orwell’s Animal Farm might not be behind what the Reserve Bank of India has proposed for banks, but it sure seems to be inspired from the above line. The RBI, in a draft circular on Thursday, has proposed that banks must set aside more reserves from April 1, 2025, towards liquidity coverage ratio against deposits that have a digital enabler attached.

Simply put, the term deposit you opened through a few clicks online and your savings account that allows you to scan and pay through UPI, will need your bank to invest more in government securities. But the deposit your boomer parent opened by walking to the nearest branch and getting the physical certificate will be termed as less of a flight risk for the bank.

So much for chest thumping over digital prowess. It is not that the RBI doesn’t want banks to become digital power houses and offer the best to their customers. In fact, its recent spree of penalties and business restrictions on big lenders to punish them for digital lapses shows otherwise. What the banking regulator simply wants is for banks to take a lesson from the SVB debacle in the US.

Silicon Valley Bank went bust in record time after a run on it where most depositors withdrew money online within minutes. That is the power of digital banking services. It can bring unparalleled convenience to people and unprecedented pain to banks during tough times. While SVB has been termed as an isolated case because of its clientele, it holds significant lessons for bankers everywhere.

India’s banks cannot go back to long time overruns in their core business if they must keep up with modern technology. Given that UPI has taken Indians leaps ahead, banks must safeguard themselves from situations where a run on them would be lethal. To that extent, the RBI’s proposed norms are sound. It recognizes the transformed nature of banking today and has updated regulation to cater to new challenges. After all, misinformation through social media is rampant and even a not-so-troubled bank can quickly be pushed to its demise through runs instigated by fake news.

That does not mean banks have to like it or even their investors. Banking stocks came under pressure today because setting aside more reserves would mean having less money to lend. That would automatically tighten credit and leave banks with less to lend. ICRA analysts estimate that the revised LCR requirements will be Rs 4 trillion for the banking system, a huge number to be set aside. The high credit-to-deposit ratio that has been bothering the RBI for quite some time will now come down.

Banks will not only have less money to lend, but the high quality liquid assets that they must keep under LCR are those that offer low returns such as government bonds. That means not just less credit offtake but also more money into low margin assets. Ergo, analysts are pencilling in further contraction in net interest margins for banks, at a time when NIMs are already shrinking. “Banks do carry buffers over LCR norms, but to maintain current levels they may need to increase deposit growth/trim loan growth, which could affect earnings by 4-10%, with a higher impact on PSU banks,” note analysts from Jefferies in their report.

What are the options for banks? Crank up the fight for deposits to keep up with credit growth?

Kotak Institutional Equities believes that would be unnecessary. “Banks can rebuild to a higher ratio over time rather than looking to comply immediately in 1QFY26 as they would need 3-4 percent points of retail deposits in this challenging deposit mobilization period,” they wrote. Chasing deposits that are already hard to come by through interest rate hikes would be a NIM hara-kiri.

The intended outcome is to build a robust banking system that would be able to withstand deposit runs in a digital world. But the unintended consequences have to be taken into stride by the RBI. Those are the short-term big hit on banks’ earnings (which is really not a concern for the regulator) and the extra demand for government bonds (which is actually very good).

We know how Animal farm ended. But in the RBI’s case, the outcome is bound to be much better by way of a more fortified banking system.
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Aparna Iyer
Moneycontrol Pro