The Reserve Bank of India (RBI) has embarked on a period of accommodative monetary policy, characterized by significant repo rate reductions and a stated commitment to keeping rates "lower for longer" to stimulate economic growth. Yet, beneath the surface of these policy adjustments, a persistent and complex challenge confronts the nation’s banking sector: the widening divergence between credit expansion and deposit accretion. While banks have responded by adjusting both lending and deposit rates, the fundamental imbalance in the credit-deposit ratio continues to pose critical questions for financial stability, liquidity management, and the overall efficacy of monetary transmission within the world’s fifth-largest economy.
Monetary policy transmission, the process by which central bank actions influence market interest rates and broader economic activity, is a key focus for the RBI. Historically, the speed and extent of this transmission have varied across different segments of the banking system. In the current cycle, the RBI has lowered the benchmark repo rate by a cumulative 125 basis points (bps), aiming to foster a conducive environment for borrowing and investment. The observed changes in lending and deposit rates reveal an intricate pattern of adjustment, often not entirely synchronous, reflecting diverse institutional structures and market pressures.
Analysis of recent data reveals that the weighted average lending rates on fresh loans across the banking system saw a notable decline of 66 basis points over the past year, settling at 8.67% by January 2026. This aggregate figure, however, masks significant variations among different banking segments. Foreign banks, often characterized by more agile balance sheets and a distinct customer base, led the charge with a substantial 148 bps reduction, bringing their average lending rate to 7.81%. Private sector banks also demonstrated a robust adjustment, with rates falling by 88 bps to 9.32%. Public sector banks, which constitute a dominant segment of the Indian financial landscape, experienced a comparatively more modest dip of 54 bps, bringing their average to 8.05%. This differential pace underscores the varying sensitivities of different bank categories to monetary policy shifts, influenced by factors such as funding profiles, competitive dynamics, and the composition of their loan books.
On the liabilities side, the transmission of lower rates to depositors has been even more pronounced in absolute terms. The banking system’s deposit rates collectively stood 96 basis points lower in January 2026 compared to January 2025. Here too, foreign banks were observed to have outstripped their domestic counterparts in reducing deposit rates. Despite this larger absolute reduction in deposit rates, Jahnavi Prabhakar, an economist at Bank of Baroda, noted in early March that the transmission has been "more pronounced for the lending rates than deposit rates." This perspective suggests that while deposit rates have indeed fallen, the impact or speed of adjustment in lending rates, particularly those linked to external benchmarks, might be perceived as having a greater immediate effect on economic activity and borrower sentiment, or perhaps the reference points for comparison are different for lending vs deposit rates.
The effectiveness of monetary policy transmission has been significantly bolstered by the RBI’s directive in 2019, mandating banks to link their retail and small business loans to external benchmarks, predominantly the repo rate. This policy shift has ensured that interest rates on these loan categories respond with near immediacy to changes in the central bank’s policy rate, enhancing transparency and improving the responsiveness of the credit market for a substantial portion of the economy. In contrast, loans to large corporations continue to be predominantly linked to the Marginal Cost of Funds-based Lending Rate (MCLR), an internal benchmark that adjusts more gradually, reflecting banks’ own cost of funds. Both external benchmark-linked and MCLR-linked loans operate on a floating rate basis, meaning their interest rates fluctuate over the loan’s tenure.
The structural shift towards external benchmarking is gaining momentum. As of September 2025, external benchmark-linked loans accounted for 65% of all floating rate loans, a notable increase from 59% a year prior and 56% two years earlier. This trend signifies a progressive alignment of the banking system with the RBI’s monetary policy signals. While public sector banks traditionally had a lower share of external benchmark-linked loans due to their larger exposure to corporate credit, data from September 2025 marked a historic turning point. For the first time, external benchmark loans surpassed MCLR-linked loans in state-owned banks’ portfolios, indicating a significant transformation in their lending practices and a stronger linkage to the central bank’s policy stance.
Despite these advancements in monetary transmission, the fundamental challenge of the credit-deposit gap persists, and indeed, appears to be widening. Latest data released by the RBI on February 27, covering the fortnight ending February 15, revealed that bank credit growth stood robustly at 13.4%, while deposit growth trailed at 11.2%. This gap of 2.2 percentage points represents a notable expansion compared to the same period last year, when the difference in growth rates was a narrower 64 basis points. This sustained divergence signals a structural imbalance, where the demand for credit from a growing economy consistently outstrips the rate at which banks can attract new deposits.
RBI Governor Sanjay Malhotra, in a recent interview, offered a nuanced perspective on this phenomenon, highlighting that banks inherently possess the capacity to "create deposits through credit." He also pointed out that the seemingly lower deposit growth rates are relative to a significantly larger existing deposit base of approximately ₹250 trillion, compared to a credit base of around ₹205 trillion. While this perspective provides context, the widening gap nonetheless creates operational challenges for banks, including pressure on liquidity management and potential increases in their cost of funds as they compete more aggressively for deposits or seek alternative, often more expensive, funding sources. This dynamic is not unique to India; rapidly growing emerging economies often face periods where robust credit demand, driven by consumption and investment, outpaces the slower, more organic accumulation of savings within traditional banking channels.
Analyzing the quarterly data from the RBI further illuminates the structural characteristics of the Indian banking sector. India’s state-owned banks have largely maintained their dominant market share in both loans and deposits. As of December 31, public sector banks commanded a 57.5% share of total deposits, a slight decrease from 57.8% in the previous year, while private sector banks held a 36.1% share, up marginally from 35.9%. In the realm of credit, state-owned banks accounted for 54.4% of the market, compared to 53.5% a year prior, while private sector banks held 40.7%, a slight dip from 41.5%. These figures underscore the continued significance of public sector lenders, even as private players demonstrate agility and capture incremental gains.
A detailed analysis by Kotak Institutional Equities in early March shed further light on deposit trends. It indicated that while household deposits continue to dominate the overall deposit base, their growth has been relatively modest. Conversely, deposits from non-individual entities have shown a marginally faster pace of growth. A critical observation was the continued weakness in Current Account and Savings Account (CASA) deposits, which are the cheapest funding source for banks. This weakness in CASA, coupled with the rising credit demand, is compelling banks to increasingly rely on more expensive term deposits. The analysis also noted that the repricing of term deposits has indeed begun, signaling banks’ efforts to attract funds by offering more competitive interest rates on fixed-term instruments, thereby pushing up their overall cost of funds.
The persistence of the credit-deposit gap necessitates proactive strategies from banks to ensure sustainable growth and maintain robust liquidity. This often involves more aggressive deposit mobilization campaigns, offering slightly higher rates on term deposits to attract household and corporate savings, and exploring diversified funding avenues such as bond issuances and interbank borrowings. The challenge for banks lies in balancing the need for credit expansion with the imperative of maintaining healthy Net Interest Margins (NIMs), especially when deposit rates are being driven up by competition while lending rates, particularly for external benchmark-linked loans, are more directly influenced by the RBI’s accommodative stance. Managing asset-liability mismatches and adhering to capital adequacy requirements become paramount in such an environment.
The broader economic implications of this banking dynamic are significant. A sustained and widening credit-deposit gap, if left unchecked, could eventually lead to an upward pressure on interest rates, as banks compete more fiercely for funds, potentially dampening future credit growth and investment. Rapid credit expansion, particularly if not adequately backed by stable funding, could also pose risks to financial stability, though the RBI’s prudential oversight remains vigilant. Furthermore, an imbalance could fuel demand-side inflationary pressures if credit outpaces productive capacity, complicating the central bank’s efforts to manage price stability. For specific sectors, robust credit availability is crucial for growth, but the cost of that credit, influenced by funding dynamics, directly impacts business profitability and consumer affordability.
Looking ahead, the resolution of the credit-deposit paradox will depend on a confluence of factors. Continued strong economic growth could further stimulate credit demand, while household savings behavior, influenced by inflation, real interest rates, and alternative investment opportunities, will determine deposit inflows. The RBI will likely maintain its close watch on banking sector liquidity and stability, potentially employing macro-prudential tools if the imbalance becomes excessive. As India’s financial landscape continues to evolve, shaped by digitalization and increasing financial inclusion, the ability of banks to effectively manage their funding base will be crucial for navigating a dynamic economic environment and ensuring the sustained health of the financial system. The current juncture represents a critical period for Indian banking, where balancing growth aspirations with prudent liquidity management remains the paramount challenge.
