Daily Editorials for UPSC IAS Exam Preparation

Daily Editorial – A critical analysis of effects of demonetization on Banking Industry

  • A critical analysis of effects of demonetization on Banking Industry

  1. Introduction
  2. Positive effects on banking industry
  3. Negative affects
  4. Options available with banks and their feasibility
  5. Dilemma faced by banks
  6. Issue of cooperative banks

Click here to Download Daily Editorial PDF (1st Dec. 2016)


Demonetization is a generations’ memorable experience and is going to be one of the economic events of our time. Its impact is felt by every Indian citizen.

Banks work as a lifeline for any economy; any positive or negative effect over them also affects economy of the country proportionately. Hence, it becomes important to know how recent Demonetization will affect the banking industry.

The total value of old Rs.500 and Rs.1000 notes in the circulation is to the tune of Rs.14.2 trillion, which is about 85% of the total value of currency in circulation.

This means that the total cash has to now pass though the formal banking channels to get legitimacy. Banks are getting heavy amount of cash daily. Would that be beneficial or harmful for the banking industry?

Positive effects on banking industry

  • Banking System will get a boost, as more than Rs 7-8 lakh crore base money (new legal money) will enter the system.
  • Banks will get the much needed liquidity.
  • Banks will get a lot of CASA (current and savings account) deposits coming at a huge spread to them.
  • Increase in the current accounts and savings account will increase the Net National Income and Net earnings of the banks.
  • More funds deposited in the current and saving account means, banks get funds at either no or at very low cost.
  • As the banks get a lot of liquidity they may lend the money at very low interest rate.
  • Banks will be paying an interest of 2-3% on deposits and will be deploying them at 6-7%. This gives them a spread of 3-4% on a huge sum of deposits
  • Banks will not need to look for the other sources like RBI or government for funds.

However, effects of demonetization on banking industry are not all positive, it has negative affects too.

Negative affects

  • Thus now banks will have to service the cost of these fresh deposits without earning commensurate income on them
  • And it will negatively affect their NIIs and their profits.
  • Banks are not in a position to significantly increase lending and their capital base may get worse.
  • NPAs may spike if the economic activities slows down further due to currency ban.
  • Normal banking business has been disrupted and bank employees have been occupied in dealing with exchange, deposits and withdrawals of currency.

Options available with banks and their feasibility

In the absence of the option of making loans by deposits, banks are left with only 2 options:-

  1. Depositing funds in reserves with RBI

As these reserves do not earn interests, banks would not prefer that option.

Recently RBI decisions to make it mandatory for banks to hold 100% CRR on incremental deposits, prevents banks from investing the incremental deposits in G-secs.

  1. Investing in Government Securities (G-secs)

Banks may prefer this option as G-secs being sovereign bonds do not pose any capital requirements on banks.

Viability of G-Secs- Availability of G-secs in the market is determined by the borrowing program of the government and is not easy to expand without raising fiscal concerns.

Since there has been no announcement yet on the expansion of the supply of G-secs, with more incoming deposits, RBI will soon run out of G-secs that are needed to absorb the excess liquidity.

  1. Lowering deposit rate

Another option with the banks is to lower the deposit rates.

But lowering deposit rates below 4% may cause a public uproar. Hence it is highly unlikely that banks may take this step.

Dilemma faced by banks

  1. Uncertainty over deposits

As the banks do not know how long these deposits will stay on their books, can deploy these deposits only in short-term assets.

  1. Burgeoning NPAs

In June, gross NPAs (GNPAs) of listed banks were Rs6.7 trillion or 9.1% of their advances.

The 27 public sector banks (PSBs) account for 80% of these NPAs. In 15 of them, GNPAs as a percentage of advances are more than or close to the capital to risk weighted assets ratio (CRAR).

Except for the State Bank of India and a few other PSBs, the CRAR with other banks does not allow them to make new loans.

  1. Low demand for loans

The currency ban has imposed a big negative shock on consumption demand, which in turn may lead to businesses cutting back on their working capital requirement.

Hence Corporate credit demand has been slow.

Issue of cooperative banks

Restrictions on Cooperative banks

Cooperative banks have been barred from accepting the old Rs 500, Rs 1,000 currency note deposits or exchange those notes with the new currency notes.

This meant that these lenders could only deal with permissible denominations of Rs 100 and below or takes deposits in new currencies.

Choking funds to cooperative banks can inflict significant damage to the health of several cooperative banks.

Following restrictions, there has been hardly any business in cooperative banks across the country.

Reasons of putting ban

  • Checks and balances at these banks aren’t perceived to be strong enough to counter efforts to push black money into the banking system.
  • These banks aren’t as tightly regulated as scheduled commercial banks.
  • Most of these banks are indirectly controlled by politicians or local businessmen.

Why survival of cooperative banks is important:-

  • Cooperative banks have been the trusted centers to bank for millions of farmers and middle, low-income people for long.
  • These institutions are known to offer them easier loan and deposit products and hence are the favorite institution for the poor.
  • Other options likeBanking Correspondents (BCs) system haven’t worked well so far.

Importance of banking industry for our economy is not needed an explanation, government must come up with some important measures to tackle the problems facing banks due to demonetization.

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