How Banks Actually Create Money in India | Ex-SEBI Official Explains

Summary of key arguments and commentary

• Money creation is framed as interconnected with currency, interest rates, commodities, credit, and equities. The speaker argues you cannot analyze currency markets in isolation; balance sheets and policy transmission link multiple asset classes.

What creates money (core explanation)

1. Bank lending to the private sector

   • When a bank makes a loan, it creates a deposit at the same time.
   • In the “banking system as a whole,” loans create deposits, rather than deposits “enabling” loans.

2. Bank lending to the government

   • Buying government bonds (or otherwise financing the government) also results in additional banking-system activity.
   • When the government then spends the money, deposits are recreated through the spending process.
   • The speaker presents this as conceptually similar to private lending, with some steps routed through the RBI.

3. Net foreign exchange (FX) inflows

   • When dollars enter the economy (e.g., via FDI), deposits rise because banks must credit rupees to the recipient.
   • If banks cannot safely hold the FX risk, the RBI absorbs it into FX reserves, converting FX inflows into rupee liquidity, supporting higher deposits.

Currency notes as a “leak” from deposits

• Currency issuance is done by the RBI (notes are liabilities of the RBI—“currency in circulation”).
• When people withdraw deposits as cash:
  • Deposits fall
  • Currency in circulation rises

What destroys money / reduces deposits

• Loan repayment reduces both loans and deposits.
• FX outflows reduce deposits because rupees are used to buy dollars (the RBI sells FX).
• Government actions that remove balances from the spending loop—e.g., tax payments—can reduce deposits if not immediately offset by spending.
• The speaker also notes that certain non-bank lending structures (e.g., NBFC lending) do not create net new deposits the way bank lending does; they are largely transfers within the banking system.

Why banks still face constraints even if loans create deposits

• The speaker argues it’s not primarily a funding shortage; deposits can be created via lending.
• Instead, constraints relate to:
  • Regulatory liquidity (LCR)
  • Capital
  • The need for stable / low-outflow deposits
• With low interest rates and taxation, households are less likely to park money in fixed deposits.
  • This leaves banks with more short-term / wholesale-like funding, assumed to be more “likely to run off,” increasing liquidity pressure.

FI24–FI26 as the policy/market transmission case

• The speaker highlights large net FX pressure:
  • RBI sold large amounts of dollars to protect the rupee (cited as $192 billion across spot/forward markets between FY24 and FY25, continuing afterward).
• Deposits fell due to net FX outflows, while:
  • Government borrowing and issuance rose
• Despite this, the RBI is described as cutting rates / supporting bond prices by buying government securities:
  • cited as roughly 10 lakh crore in bond purchases between FI25 and FI26 to keep government bond yields low (e.g., a 10-year yield down to ~6.25%).
• Result:
  • Banks could show “liquidity” (balances with RBI above CRR),
  • but still faced a shortage of “good quality” deposits, leading to higher rates in instruments like CDs.

Equity as an alternative destination under low fixed-income attractiveness

• Because fixed income became less attractive (rates low and taxation makes after-tax returns unattractive), money shifted toward equities.
• The speaker cites:
  • strong retail participation
  • large equity flows (e.g., demand via mutual funds/insurance/pension-type channels and IPO/supply dynamics)
  • demand-supply imbalance sometimes met via promoters selling in the secondary market

Currency weakening beyond “real” current account deficits: role of hedging/speculation

• Central claim: RBI sold far more dollars than justified by core fundamentals.
  • Current account deficit + net FDI/FPI flows are described as much smaller than total RBI FX sales.
• The difference is attributed to:
  • interest-rate differentials enabling hedging and speculative dollar demand
  • forward hedging becomes cheap when the India–US interest differential is small
• Therefore, the speaker rejects the TV talking point that “defending the currency with interest rates” is the explanation.
  • Instead, low rates allegedly contributed to rupee weakness through capital-flow and hedging channels.

Why markets may look “stuck” even with domestic inflows

• The speaker suggests equity issuance/flows became more balanced in FI26 vs FI25 (demand/supply mismatch reduced), but issues remain due to ongoing flow/outflow patterns.
• He also argues India’s credit markets are relatively underdeveloped versus equities:
  • citing credit-to-equity ratios compared with other countries
  • attributing this partly to interest rate suppression and tax treatment pushing investors toward equities

Policy “way forward” proposed

• The speaker recommends letting interest rates reflect demand/supply more freely, with minimal intervention.
• Key lever: reduce the tax burden on interest income
  • to make fixed income competitive with equity after tax
  • so capital can allocate appropriately between fixed income and equities
• Controversial proposal: allow some Indian residents to invest overseas in a calibrated way
  • to avoid inefficiencies and brittle flows from forced concentration of savings into domestic equities
• Durable solution: real economic growth
  • jobs and manufacturing
  • because finance and capital markets will stabilize if the underlying economy performs

Presenters / contributors

• Anand Narayan (Professor of Practice, IIT Bombay School of Management; Former SEBI whole-time member; senior India analyst, Observatory Group)