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How The Stampede to Deposit Money is Hurting Banks in India

The opposite of a bank run, it turns out, isn’t a good thing either. In the case of India, it is a total banking mess.

India’s big bang demonetization program, aimed at rooting out “dirty” money from the economy, has forced $80 billion worth of old rupee notes into bank vaults. At first, this seemed like a boon for banks, who were suddenly flush with cheap funding.

This forced short-term interest rates to the bottom of the Reserve Bank of India’s policy rate corridor. India’s largest state-backed lender in turn cut deposit rates. Other large lenders followed. While low rates sound great, the central bank got jittery that there was too much cash sloshing around.

In response, the RBI temporarily raised the cash reserve ratio to 100% of excess deposits from a mere 4%. The effect was to suck $50 billion from the banking system. It was a costly move, depriving India’s already-struggling banks of $75 million to $90 million in foregone profits a week.

Squeezing banks erodes their role as agents of monetary policy. The central bank doesn’t pay interest on these reserves, and banks still have to pay customers’ deposit rates, which are close to 4%. That squeezes net-interest margins and reduces the likelihood that banks can pass on lower lending rates. Over the second half, banks could lose as much as 0.15 percentage point in net interest margin, Deutsche Bank analysts estimate.

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(via WSJ)