Bank Deposit Franchise, Interest Rate Risk, And Credit Booms: Evidence From India

Deposit franchise allows banks to pay deposit rates that are low and insensitive to market interest rates. However, maintaining this franchise requires high fixed costs. In order to hedge against interest rate risk arising from these fixed costs, banks with strong deposit franchises seek to reduce sensitivity of their interest income to market rates by holding longer-term fixed-rate assets. We provide evidence for this theory from India, and show that this behaviour can help partially rationalise India’s infrastructure credit boom of the 2000s. During this period, banks with stronger deposit franchise switched from long-term government securities to long-term fixed rate loans, particularly in the infrastructure sector. We highlight that rising bond yields and associated mark to market losses on bond holdings may have exacerbated the switch towards risky infrastructure sector, eventually resulting in high non-performing loans. Overall, while maturity transformation allows banks to shield their net interest margins from interest rate risk, we propose that market incompleteness in developing economies may lead to a trade-off between stabilising net interest margin and default risk.