Effects of demonetization on banks

By Ruchika Jha - September 17, 2020

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On 8th November 2016, at 8:15 pm, the country was shaken. Prime Minister Narendra Modi’s government
made an announcement which shook the entire country and led many in the country stand in long lines the
very next day. This was demonetization. The concept of demonetisation means that the country’s currency
which was in use was no longer valid and the entire cash currency was to be changed. It is basically the act
of taking way the status of a legal tender of the Rupee, the currency of India. It usually takes place through
pulling the already distributed cash in the economy and changing it or replacing it with the new money, i.e.
in form of notes or coins. Many a time, the country changes the entire currency structure. In India,
however, demonetization had impacted the Rs 500 and Rs 1000 notes. Overnight, the existing notes were
no longer valid. The printing of Rs 1000 note was discontinued and a new note of Rs 2000 was introduced.
In the weeks that followed the announcement, there was havoc in the country. People were standing in long
lines in front of banks, ATMs for the exchange of their cash and to withdraw cash. India, primarily being a
cash economy, where majority of transactions take place in cash, it was an utter shocker and a chaotic
situation. Further, the demonetization was on Rs 500 and 1000 notes which account for 86% of the cash
currency running in the market. This led to a liquidity crunch in the short run as many of the banks were
unable to exchange cash due to the shortage of money. According to a study conducted by the Reserve
Bank of India, the regulator of the economy, there have been 15.30 lakh crore bank notes which have been
demonetized.

According to policy makers, the primary reason for this decisions was that it was to tackle black money in
the economy. Further, from the very beginning of the 2014 term of PM Modi, he has been envisaging a
digital economy with very little cash truncations. Thus, he wanted to fulfil this by eliminating the big value
notes in the economy. Further, this was done to ensure effective tackling of the black money. Black Money is
often stored in cash in people’s houses and thus, demonetization would help in reduction of corruption in
our country. Another reasoning given by the policy makers is that fake currency is increasing becoming a
source of funding for illegal and illicit activities. This step would help in tackling these illegal activities and
terrorism. Though these, pretty big problems in the country, however, demonization didn’t have much
impact on these according to several experts. They are of the opinion that demonetization caused much x
harm than good. One such was the banking sector which is elucidated in the present article.

Banking may be defined as the commercial activity of accepting and safeguarding money owned by other
individuals and entities, so lending out this money so as to earn a profit. However, with the passage of your
time, the activities covered by banking business have widened and now various other services also are
offered by banks. The banking services nowadays include issuance of debit and credit cards, providing safe
custody of valuable items, lockers, ATM services and online transfer of funds across the country. Banking
plays a very important role in our everyday lives. They act as financial intermediators who help in providing
funds to the creditors and absorbing any risk entailing in the loans and keep the country’s engine going.
Banks form the core a part of any economy. They channelize the money for the functioning of various
sectors. They are at sources of exchanges of currencies. In such circumstances when they act as post of
exchange of currencies, a move like demonetization can have a disastrous impact on ill prepared bans. In
fact this is what had happened in the after math of the announcement of demonetization.

An overall analysis of the move of demonetization, after four years shows that the banking sector faced the
following.

Increase of deposits: x
The banned notes of Rs 500 and Rs 1000 accounted for 86% of the currency circulated in the market. This
meant the individuals had to submit their money and in exchange get the money bank. As the individuals
who had the money where so many, there was an increase in the deposits in the banks. There was a sudden
increase in the bank cash liquidity ratio and the size of public deposits had significantly increased.

Shortage of liquid cash:

Liquid cash implies the currency notes or coins in the hands of the consumers. After the demonization, the
people of the country were squabbling over the lack of cash in their hands. Or even if they had the cash
they were unable to use it as it had become illegal. People stood out in lines over hours in front of banks
and ATMs to get their money exchanged. In fact this led to widespread protests in the country. A few deaths
were also reported in the country due to exhaustion and heat. This had a huge impact on the economy with
the stock markets plummeting and big business corporations losing thousands. In addition, several
economic problems were created by this movie. It disrupted the entire supply and demand chain which is
largely a cash based chain. The prices of essential commodities increased and petrol and diesel prices were
also impacted. In fact, according to many studies, the worst hit were the small time traders who though
didn’t have a bank account and now their entire livelihood was threatened.

Demand for government bonds

People increasingly started investing in government securities and government bonds as the stock markets
were in pretty bad conditions and the government bonds acted as safe havens for the investors. Many
public sector banks used this opportunity to use the excess cash in their banks to use as government bonds.
This would eventually result in huge turnover for the banks. It will result in a likely 20-25% increase in the
earnings and revenue of the banks.

Decrease in interest rates:

There was a surplus of cash reserves at the banks. This meant that the rates set by the RBI, including the
CLR and CRR were fulfliied and additional money was left. Thus many banks stated giving out loans at a
lower interest rate. This, this move resulted in many private and public sector banks significantly increasing
their loans capacities. In fact, according to one such study, it had almost increased by 20%.

Increase use of bank accounts:

Demonetization though had a number of pitfalls, however, it steadily increased in people having a bank
account. This move was coupled with the initiatives by the government to engage in people having a bank
account. This led many poor families and individuals below the poverty line to open zero bank account,
which would help them being connected with government initiatives and providing an avenue for storage of
money.

UPI and advent of online banking

With a crunch of cash in the economy many people turned to digital payments and plastic money. The x
online banking platform increased significantly. In fact, people used platforms such as Paytm and PhonePay
more than they were first launched. In cities, there was a 42% in the use of credit and debit cards by the
consumers in the markets. This thus helped people to engage in digital interface which traditionally do not.
There was a steady increase in digital payment and tools.

Crippling of rural banking:

The worst affected banks were in fact the rural banking sector. Rural lending is mainly catered by public
sector banks. There was a severe falling of credit growth in these banks especially in rural areas
predominated by agriculture. There was a fall by 6.1% in the economic year of 2017.

Losses suffered by banks:

The provisions of demonetization was not all rosy. It created significant problem in the banks and banking
sector in general.

i) There was loss of bank revenue in the form of no charge towards the ATMs. It made the banks almost to
lose Rs 100 per day.
x
ii) There were many other discounts and offers provided by the banks to ease the pain of the consumers.
One such as the merchant discount rate on credit and debit cards. It resulted in a huge loss to the bank
revenue with 1% in every transaction.

iii) The banks didn’t have an interest on the surplus deposits. There was an increase in Rs 3 Lakh Crore in
the form of cash reverse in the banks. However, there was no interests on such amount for almost one
month.

iv) Increase in logistics expenses such as transportation vans. They were significant used during this period
and to move such huge amounts of cash to the Reserve Bank of India, was a problem of its own.

v) There was a sudden drop in consumers willing to spend on high value items such as cars and houses.
This resulted in losses to banks.

Reduction in MSME businesses:

The most impacted sector was the MSME. There was a decline in small and medium enterprises and thus
loss was caused to them. This resulted in them missing on the instalments of the banks and thus it caused a
crunch in the economy. According to a study there was decrease of about 60% in the business of such
companies. Thus, it adversely increased the Non-performing assets of the country.

Strain on employees:

Bank employees were kept under stress and they were working overtime for almost two months after the
announcement of demonetization. Due the immense pressure, it resulted in a number of problems in lives
of bank employees. With witnessing a flurry of customers every day, it was a difficult task.

Conclusion:
The concept of demonetisation means that the country’s currency which was in use was no longer valid and
the entire cash currency was to be changed. In India, which is primarily a cash based economy, people have
faced immense inconvenience because of demonetization.It caused a number of problems in the economy.
However, they have been a pros such as increase in the use of plastic cards, online banking etc. however
with the increases cons, it seems that it was a very bad policy decision on the part of the government.

“The views of the authors are personal“

Frequently Asked Questions

What is demonetisation?

The concept of demonetisation means that the country’s currency which was in use was no longer valid and
the entire cash currency was to be changed. It is basically the act of taking way the status of a legal tender
of the Rupee, the currency of India. It usually takes place through pulling the already distributed cash in the
economy and changing it or replacing it with the new money, i.e. in form of notes or coins. Many a time, the
country changes the entire currency structure.
Why did Indian Policy makers decide on demonetization? x

According to policy makers, the primary reason for this decision was that it was to tackle black money in the
economy. Black Money is often stored in cash in people’s houses and thus, demonetization would help in
reduction of corruption in our country. Another reasoning given by the policy makers is that fake currency is
increasing becoming a source of funding for illegal and illicit activities. This step would help in tackling these
illegal activities and terrorism.

How did demonetization occur in India?

In India, demonetization had impacted the Rs 500 and Rs 1000 notes. Overnight, the existing notes of Rs
500 and Rs 1000 were no longer valid. The printing of Rs 1000 note was discontinued and a new note of Rs
2000 was introduced. Further, a new Rs 500 currency note was introduced.

What was the impact on banking sector?

Banks are chief institutions affected by demonetization. Though it affected bank operations, it helped the
economy to find growth of the country through financial institutions. It has caused problems to bank x
employees as their job increased significantly. Demonetization, however has also introduced a slew of
positive aspects such as increase in the use of plastic cards, online Banking etc.

Related

Offences related to coins & Introduction and Basic Concept of Characteristics and functions of
currency Income Tax Central Banks
September 18, 2020 November 21, 2018 October 20, 2020
In "Indian Penal Code" In "Articles" In "Banking"

Ruchika Jha
My Name is Ruchika Jha and I am from Jaipur, Rajasthan. I have completed my schooling from Delhi Public School R.K.Puram
and currently in my penultimate year of law school at Hidayatullah National Law University. I am interested in Banking and
Structured Finance. I enjoy cooking, traveling, writing and research. I strive to better myself every day and work in a dynamic,
challenging, work-oriented environment to accomplish my desire to seek more knowledge.