For banks in India, continued reduction in credit costs will offset an expected shrinkage in net interest margin (NIM) this fiscal, keeping return on assets (RoA) stable. The last three fiscals saw a turnaround in performance of banks after nagging challenges in the preceding five.
The banking sector reported subdued profits and even losses in fiscal 2018 and 2019 as heightened stress in asset quality--gross non-performing assets (NPAs) peaked at 11.2 percent as of March 2018--affected profitability and capitalisation. Public sector banks took longer to turn around, reporting profits only in fiscal 2021, after five straight years of losses.
Since fiscal 2021, however, bank profitability has improved, riding largely on reduced credit cost, which is estimated to have dropped to 0.7 percent in fiscal 2023, down from 2.3 percent in fiscal 2018.
Additionally, in fiscal 2023, profitability was boosted by a significant expansion in the net interest margin (NIM). Coupled with lower credit cost, the NIM expansion of around 30 basis points (bps) catapulted profitability to a decadal high, with banks reporting RoA of 1.1 percent for the fiscal.
Interest income rose sharper than deposit cost for most of last fiscal, benefitting NIMs, for two reasons:
1. About 80 percent of banking sector advances are on floating interest rates. While this number hasn’t changed materially in the past few years, around half is now linked to external benchmarks, such as repo, as against sub-10 percent three years ago. These loans tend to re-price upwards faster when interest rates rise. The rest of the floating-rate loans are largely linked to the marginal cost of funds-based lending rate (MCLR). Here, too, lending rates move up in a rising-rate environment, but with a lag and to a lesser extent. Liabilities, on the other hand, are dominated by deposits that predominantly have a fixed cost, with any hike in interest rate applicable only to incremental deposits and renewals.
2. Banks started raising deposit rates well after the surge in lending rates, even though the pace of deposit growth was slower than credit growth last fiscal. That’s because banks initially dipped into their surplus liquidity to support credit growth rather than raise deposit rates. This is reflected in the reduction in excess statutory liquidity ratio (SLR) held by banks to 8.5 percent of net demand and time liabilities (NDTL) in March 2023 from 10.4 percent in March 2022.
The different pace of rate changes for loans and deposits boosted NIM to an estimated 3.2 percent last fiscal from 2.9 percent in fiscal 2022, with a few banks even seeing as much as 50-60 bps jump.
That said, CRISIL Ratings believes NIMs have peaked and will contract 10-20 bps to 3.0-3.1 percent this fiscal as deposit rate hikes take effect better.
Competition for deposits
Competition for deposits has led to rates being hiked since October 2022 and this could continue given that deposit growth continues to lag credit growth. Even with some pick-up in the last quarter, deposits grew only around 10 percent in fiscal 2023 compared with over 15 percent growth in credit. In the first quarter of fiscal 2024 though, deposit growth rates have moved up to 12.4 percent as of the beginning of June.
With an estimated 30-35 percent of deposits expected to come up for re-pricing at higher rates this fiscal, and the shift from current and savings deposits to term deposits continuing, overall deposit costs will rise. With credit demand remaining healthy across segments, the race for deposits could also see some banks relying even more on higher-cost bulk deposits, further impacting deposit cost.
And given that most of the re-pricing on the assets side has already been done, the NIM gains of last fiscal may dissipate.
Pause on repo rate hikes
The Reserve Bank of India has hit the pause button on repo rate hikes for the time being, keeping rates unchanged in the last two monetary policy cycles. This will limit the ability of banks to increase lending rates on external benchmarked linked loans. Of course, the second-order effect of a rise in cost of funds on MCLR will, in turn, have a benefit on the assets side with somewhat higher lending rates. But the extent of that will be relatively less.
Nevertheless, while banking sector NIMs will shrink this fiscal, overall profitability will remain steady after rising for three straight fiscals. This is because continued reduction in credit cost will offset the contraction in NIMs and support overall profitability.
Gross NPAs have already hit a decadal low of about 3.9 percent as of March 2023, and leading indicators such as the quality of the corporate loan portfolio and the CRISIL Ratings credit ratio 1 point to a further reduction in gross NPAs this fiscal. Also, provisioning coverage ratio is at an all-time high of about 75 percent for the banking system.
Therefore, credit cost, which had started to correct in fiscal 2021 from 1.8 percent on average between fiscals 2016 and 2020, is estimated to have dropped to 0.7 percent in fiscal 2023 and is expected to fall further this fiscal.
In addition, the drag on non-interest income from treasury losses in the initial part of fiscal 2023 is unlikely to repeat this fiscal, as rates are not expected to rise materially from here.
—The author, Krishnan Sitharaman, is Senior Director and Chief Ratings Officer at CRISIL Ratings. The views expressed are personal.
(Edited by : C H Unnikrishnan)
First Published: Aug 3, 2023 7:43 AM IST
