By Ishita Misra
On November 8th, 2016, the government made the unprecedented move to demonetise all the Rs 500 and Rs 1000 banknotes. The governments decision to render 86% of the currency in circulation invalid was aimed at clamping down on the black money circulating in the economy and promoting digital modes of payment. However, the impacts of demonetisation were not restricted to its effects on combating corruption and moving towards a cashless economy. Even though it has been a year since the economy was hit by demonetisation, the banking sector is still trying to grapple with its side-effects.
Hindering recovery
Non-performing assets (NPA) in the banking sector have been steadily rising for the past few years. NPAs refer to a category of defaulted loans, for which the principal or interest has not been paid for a stipulated amount of time. Accumulation of a high number of NPAs often leads to the banks facing declining profits. In turn, the bank credit shrinks, as they cut down on their lending activity. According to N Kamakodi, the CEO of City Union Bank, demonetisation played a big role in hindering the recovery of banks from the crisis of the NPAs. He claims that there had been an improvement in the number of NPAs in September 2016, but efforts to tackle NPAs came to a standstill after the Rs 500 and Rs 1000 notes were invalidated.
The City Union Bank CEO said that poor credit offtake and the rush at branches following the announcement of demonetisation forced banks to shift their attention from chasing defaulting borrowers to the pressing issues that the customers would face at the banks. Eventually, the weakening of loan recoveries led to the tendency of writing off loans and the NPAs were again on the rise. However, as the urgency brought on by demonetisation is fading away, the possibility of a faster recovery by the banking sector seems less grim.
Missed cycles and missed profits
Demonetisation also had severe impacts on non-banking financial companies (NBFC) and microfinance institutions (MFIs). These institutions underwent immense stress as their collection cycles went awry, after demonetisation. This is because these collections are often in the form of cash and most NBFCs and MFIs were forced to announce collection holidays till a period when there was sufficient money in the system. Furthermore, as most of the staff was busy handling the note deposits, exchange and withdrawals, operations that yield profits, such as vending loans and cross-selling investment products were neglected. In this way, the demonetisation drive led to lower earnings for most banks in the final quarter of the financial year 2017.
Changing investment habits
Despite the large-scale cash deposits in bank amounts, the bank deposits offered nominal returns. As a result, investors started exploring alternative and more attractive investment avenues. Consequently, equities and mutual funds emerged as the investment options preferred by customers and resulted in banks making even lesser profits. With a net inflow of Rs 1.46 trillion in 2017, mutual funds witnessed escalated inflows towards equity funds. Furthermore, as a large part of real estate transactions were happening in cash, buying assets in banks lost its appeal for many investors. Therefore, even retail investors slowly started moving away from low-yield assets like fixed deposits in banks and gravitated towards mutual funds.
The silver lining
Despite the numerous negative impacts of demonetisation, there was a silver lining. The liquidity boost that resulted from the multitude of people making large cash deposits after demonetisation has stayed with the banking sector. The increased liquidity has helped banks reduce their high-cost deposits and boost their current account and savings account (CASA) ratio. In turn, the increase in the CASA has led to an increase in the net interest income and the net earnings of the banks.
A Senior Analyst at the financial institutions at India Ratings & Research, Udit Kariwala, has estimated that 55% to 60% of the deposits made post-demonetisation have remained with the banks in the form of fixed deposits or CASA. He mentioned that all the banks have benefitted from this boost in liquidity. The public-sector banks benefited due to the mark-to-market gains that took place because of a combination of a rise in prices of government securities and a cut in their bulk deposit rates. For private sector banks, especially the ones that are building their deposit franchise, the gains occurred due to a sharp rise in CASA.
Analysing the costs and benefits of demonetisation in the banking sector, in the short term, the cost seemed to have outweighed the benefits. However, as the scars left by demonetisation are starting to fade away, the long-term impacts of demonetisation, such as digitisation of the economy, might prove to be beneficial to the banking sector and the Indian economy.
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