Indian banks' net interest margin (NIM) will face pressure in the financial year ending March 2024 (FY24) as they increase deposit rates to attract funds to support sustained high loan growth, says Fitch Ratings.
The credit rating agency expects the Indian banking sector's average NIM to slightly contract by about 10 basis points in FY24 to 3.45%, following a 15 bps increase in FY23 to 3.55%, but remain well above that in prior years from FY17 to FY22.
This contraction is consistent with the lagged normalisation in deposit rates, although banks should be able to offset some of the impact as they gradually pass-through policy rate hikes to corporate loans, which are typically slower to reprice than retail and SME loans, Fitch Ratings says in a report.
Loan growth continuing to outstrip deposit growth — as seen in the past few months — is a potential risk, the report cautions. "NIMs could face greater pressures if banks are forced to increase deposit rates further and turn to wholesale funding, for which costs are rising. The risks could be potentially pronounced if higher interest rates are unable to meaningfully moderate credit demand and increase deposit inflows as we expect under our base case," says Fitch.
The banking sector's average loan growth reached 17.5% in the first half of FY23, with the trend continuing in December 2022 as per latest central bank data, compared with Fitch's full-year estimate of 13% for FY23.
This, according to Fitch, is partly driven by pent-up credit demand and normalisation of excess savings built up during the pandemic, as well as corporate borrowers migrating from the local bond markets towards banks given the significant hardening in bond yields.
Banks will likely enjoy some pricing flexibility due to this shift, but competition among them for market share will eventually limit their ability to pass on the increase in funding costs to borrowers, the ratings agency says.
The expansion in banks' NIM in recent years to 3.5% in the first half of FY23 from 2.9% in FY19 was due to a decline in funding costs driven by a sustained period of low credit demand and high liquidity, rather than higher loan pricing, says Fitch.
"The sector's increased focus on higher-yielding segments, like unsecured personal loans, credit cards and consumer durable loans, may have helped somewhat, but the steady increase in the sector's loan-to-deposit ratio to 75% by end-December 2022, from 71% at FYE22 led to an accelerated transmission of the central bank's 225bp rate hikes in 2022 to deposit rates since 1HFY23, thus pushing up banks' cost of funds," the report says.
However, the reduction in NIM is unlikely to affect banks' profitability in the near term, says Fitch. "Higher fee income - stemming from higher loan growth - and a revival in treasury gains should broadly counterbalance the twin pressures of higher credit costs and funding costs in FY24, while supporting capitalization," it says.
"However, if margins were to drop well beyond our expectations (say by a further 50bp), the positive outlooks on some of the banks' earnings and profitability scores would come under pressure," cautions Fitch.