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India’s GDP is projected to nearly double from $3.7 trillion in 2023–24 to $7 trillion by 2030–31, driven by strong digital infrastructure, financial inclusion, and supportive fiscal policies. However, to sustain this growth, robust capital formation and increased credit flow are essential.

The current banking regulatory architecture—comprising Statutory Liquidity Ratio (SLR), Cash Reserve Ratio (CRR), Liquidity Coverage Ratio (LCR), andPriority Sector Lending (PSL)—while ensuring stability, also constrains banks’ lending capacity, particularly for the private sector and MSMEs.

Investment Needs and Private Sector Slowdown

India needs $2.5 trillion in investments, demanding an investment-to-GDP ratio of 34%. Public investment alone is insufficient due to fiscal deficit constraints, necessitating greater reliance on private capital and household savings. However, the investment-to-operating cash flow ratio for the private sector has declined from 114% in 2008–09 to 56% in 2023–24, reflecting weakening investment appetite.

Challenges in Financial Intermediation

Banks’ share in household financial savings has declined from 50% to 40%, as savers turn to higher-yield options like mutual funds. Simultaneously, banks face high regulatory pre-emptions, holding nearly 30% of deposits as non-lendable reserves, including:

• SLR (~26%), exceeding the mandated 18% due to LCR constraints,
• CRR (4%), which earns no interest.

These requirements reduce lendable resources, raise borrowing costs, and constrain credit growth, especially for MSMEs. Further, upcoming LCR norms for digital deposits could require banks to allocate 2–2.5% more to liquid assets, limiting credit availability further.

Need to Rationalize Regulations

Globally, LCR is the standard liquidity norm, but India uniquely mandates both SLR and LCR, leading to excessive capital retention in low-yield instruments. Additionally, India’s exclusion of CRR from High-Quality Liquid Assets (HQLA) reduces bank profitability. While Basel III emphasizes flexible, institution-specific liquidity planning, the RBI’s rigid mandates hinder optimal resource deployment.

Liquidity Access and MSME Credit Gap

Large corporates can access capital via equity and bond markets, but MSMEs remain dependent on bank credit, facing persistent shortages. PSL norms, which account for over 60% of bank lending, can distort credit risk pricing and misallocate capital. A revision is needed to align PSL with India’s changing economic structure.

Credit Growth and Exchange Rate Management

India’s credit growth lags nominal GDP growth, signaling underinvestment and risks to financial stability. Revisiting the credit-to-deposit (CD) ratio can help banks raise capital more efficiently. Meanwhile, defending the rupee against a strong dollar has drained liquidity without addressing currency overvaluation, which continues to hurt export competitiveness.

Way Forward

• Rationalize SLR and LCR mandates to unlock liquidity and lower interest rates.
• Revise PSL norms to reflect new growth priorities.
• Stimulate private investment through policy stability and ease of doing business.
• Deepen bond markets to diversify capital sources.
• Align digital banking fees with global norms for viability.

Conclusion

India stands at a critical juncture in its economic transformation. Reforms in banking regulation, better financial intermediation, and improved credit access are pivotal to achieving the vision of a $7 trillion economy. A forward-looking regulatory framework will empower banks to act as true engines of inclusive and sustained growth.