MUMBAI - Indian banks may be forced to compete harder to boost deposits amid tightening liquidity and rising credit demand ahead of the festive season, analysts warned.

Indian banking system liquidity slipped into deficit for the first time in nearly 40 months earlier this week, prompting the Reserve Bank of India to infuse funds into the system.

"We think the real challenge is the gap between deposit growth and loan growth, as deposit growth is weak, at 9.5% YoY – a good 600 bps below loan growth," said Suresh Ganapathy, head of financials research at Macquarie.

"Over the next few weeks, as the festive season gathers steam, liquidity will tighten further. Also, people tend to hold a lot of cash during the festive season, and that tends to worsen the liquidity situation," Ganapathy said.

Bank loans rose 15.5% in the two weeks to Aug. 26 from a year earlier, while deposits rose 9.5%, RBI data earlier this month showed.

With excess liquidity in the banking system over the last couple of years on account of the cash infused by the RBI during the pandemic, banks chose to rely on raising funds from money markets to support the prevailing demand for credit.

But with credit growth at multi-year highs and the RBI focussing on draining liquidity to curb inflation, the cheaper funding avenues are drying up.

"Banks have been laggards in raising deposit rates due to excess liquidity in the system but lending rates were raised instantaneously," said Rupa Rege Nitsure, chief economist at L&T Financial Holdings.

"This has to change and if not, RBI will come down heavily on banks. The excessive reliance on bulk deposits is bad for overall financial stability of the economy," she added.

Bankers agree that relying on the debt market to raise funds to support growth may not be sustainable.

"Borrowing from the market to fund credit growth is just one of the ways and after a while it isn't sustainable. So we will have to start raising rates more aggressively in the coming months," said a senior executive at a state-owned bank.

The average amount of CDs raised by banks in a month rose sharply to 400 billion rupees in first quarter of FY23 compared with 260 billion rupees in the preceding quarter, according to a report by India Ratings.

Other bankers concurred.

Rates for bulk deposits, or deposits of over 20 million rupees, are rising more rapidly than retail, highlighting banks' focus on raising more funds quicker.

State Bank of India's 1 to 2-year retail term deposit rate has gone up by 15 basis points in August to 5.45%, while the bank raised the bulk deposit rate for the same tenor by 75 bps to 6%.

"Credit growth typically picks up in the second half of the year and with the festival season and economy picking up we expect a strong demand, so deposit mobilisation will increase," said another banker.

Analysts believe that as the scramble for deposit intensifies, banks may feel some impact on their margins in the coming quarters.

The incremental credit deposit ratio has already crossed 100%, suggesting that banks have started lending more than the total deposits they hold.

"In the next couple of quarters there may be some impact that lenders will feel on margin as the gap between lending and deposit rate narrows but it will be a short-term impact as banks will be able to pass on the cost to the borrowers," said Karthik Srinivasan, analyst at ICRA.

(Reporting by Swati Bhat and Nupur Anand in Mumbai; Editing by Saumyadeb Chakrabarty)