Strategic Liability Management: The Backbone of Banking Stability and Growth

Maintaining the Balance while delving into the Challenges of Liability Management

The core function of banking involves accepting deposits, usually short-term, and funding loans, having longer maturities. Maturity transformation is an inherent feature of financial intermediation and banks are strongly exposed to the associated risks. As a result, strategic management of assets and liabilities is crucial to optimise profitability, improve liquidity and protect the bank against various risks. Regulatory frameworks, constitutes a greater emphasis on the asset side of the balance sheet, focusing on credit risk management and capital adequacy. This focus arises from the belief that credit defaults and asset deterioration pose the main threats to a bank’s solvency. Liquidity and funding risks, primarily stemming from liabilities, were largely viewed as an issue that banks could manage themselves without requiring any regulatory oversight and intervention.

The Global Financial Crisis (GFC) of 2008, during which banks faced vulnerabilities on both sides of the balance sheet, had posed a challenge to this approach resulting in profound changes needed to be made to the banking sector’s regulatory framework. During the crisis, many banks experienced liquidity crisis leading to insolvencies despite adherence to capital requirements, highlighting the fragility of funding structures reliant on short-term liabilities. This underscored the systemic importance of liquidity management and the need for regulatory oversight beyond asset-side vulnerabilities. The policy response was a paradigm shift that led to prescribing comprehensive global liquidity standards viz. Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) which targeted short-term and medium-term liquidity resilience.

Demonstratively, liability management is crucial not only for the stability and solvency of a regulated entity (RE) but also as a key factor influencing its return on capital and growth trajectory. From the earnings perspective, the spread on interest earned on loans and the cost of funds determines the bank’s net income and profitability. The cost of liabilities thus has a direct impact on Net Interest Margins (NIMs) and earnings ratios. For instance, the share of current and savings account (CASA) deposits in total deposits, the mix of retail versus wholesale funding and the duration of liabilities play a key role in determining the funding cost and, therefore, profitability of banks. Further, the stability of funding is the key to resilience during any crisis. It is of omnipotent importance to understand the evolution of liability management in India, changing trends in liability structure, entity-specific challenges, and regulatory expectations.

Indian banking system had undergone a strategic transformation with the broader economic reforms of the 1990s. The deregulation of interest rates and greater global integration made the risks encountered by financial institutions more complex and significant, requiring strategic management. Accordingly, the guidelines on Asset-Liability Management (ALM) for financial institutions were first issued in February 1999 with further additions in late 2000s, covering the interest rate and liquidity risks along with prudential limits and disclosure framework.

The Indian Prudential Framework incorporated the Basel Committee on Banking Supervision (BCBS) Principles for Sound Liquidity Risk Management in 2012, followed by the adoption of two minimum standards for funding liquidity viz. LCR and NSFR.  Recognising that the LCR calibrations overlooked intra-day liquidity and the increasing interdependencies within the financial system could lead to liquidity disruptions affecting payment and settlement processes, guidelines for monitoring intraday liquidity were introduced. To mitigate the concentration risk and to curtail systemic implications of uncontrolled liability of larger banks, the Reserve Bank had put in place certain limits on Inter-Bank Liabilities (IBL) for commercial banks (2007) and interbank deposit limits for urban cooperative banks (UCBs) (2009). Scheduled Commercial Banks (SCBs) (excluding small finance banks, payments banks and regional rural banks) have been permitted to set Board approved limits for borrowing in Call and Notice Money Markets, within the prudential limits for IBL. Such liability-based concentration limits are unique to India and reflect the Reserve Bank’s early cognizance of these risks.

Deposits continued to be the primary source of funds for Scheduled Commercial Banks (SCBs), amounting to ₹217 lakh crore, which represented 77 per cent of total liabilities at the end of the Financial Year 2024. In contrast, capital funds (i.e., capital, reserves & surplus) and borrowings, each constituted around 9 per cent of liabilities. The comparison of data between Financial Year: 2016 to 2024 indicates that the deposits have grown at an annual rate of around 10%, aligning with the overall balance sheet growth, and their contribution to total liabilities has remained stable at around 77%. Meanwhile, borrowings have grown at a slower rate of 3% to 7% as a result of which its share in total liabilities has decline from 11% to 9%. On the other hand, Capital Funds have grown at close to 13%, and its share has increased progressively from 7.6% to 9.3%, indicating the deleveraging of banks’ balance sheets, boosted by higher profitability and capital raising efforts.

However, during the same period, Maturity wise – the contribution of term deposits has declined from 65.8% of total deposits to 60.9%, while the shares of savings and current account deposits have increased from 25.3% and 8.9% per cent to 29.2% and 9.9% respectively.

Consequently, CASA ratio has improved from 34.2% to 39.1%. This trend may have contributed to the improvement in Net Interest Margins (NIMs) of SCBs, which has increased from 2.6% in FY 2015-16 to 3.3% in FY 2023-24.

Apart from deposits, banks raise liabilities in the form of debt capital instruments such as Additional Tier 1 (AT1) bonds and Tier 2 bonds. Furthermore, banks are permitted to issue domestic Long-Term Bonds to finance infrastructure and affordable housing loans and can also raise funds in overseas markets under the ECB route.

For Non-Banking Financial Companies (NBFCs), borrowings are a significant source of funding, amounting to ₹34.46 lakh crore or 68% of the total liabilities as of March end 2024. Within borrowings, debentures and borrowings from banks are the main contributors. This makes NBFC’s liabilities more market-driven and sensitive to interest rate changes compared to banks.

Courtesy: Reserve Bank of India

Team Maverick