Can RBI MPC’s growth push pay off as banks brace for a NIM squeeze?

The Reserve Bank of India’s decision to signal a deeper rate cut in the June 2025 policy round has brought cheer to businesses and borrowers alike. But behind the optimism, quiet anxiety brews among Indian banks. As policy rates fall further, banks are staring at shrinking net interest margins (NIMs), a crucial metric that reflects the profitability of lending operations.

Net interest margin refers to the difference between what banks earn from loans and what they pay on deposits. When the RBI cuts policy rates, banks eventually pass on the benefit to borrowers through lower loan rates. However, deposit rates tend to be more rigid, especially in a competitive banking environment where retaining retail money is critical. This squeeze between declining lending rates and sticky deposit rates is now threatening to erode banks’ margins.

“Certainly, the banks would face pressure on their net interest margins (NIMs),” said Prof. Ram Singh, a member of the Monetary Policy Committee (MPC), in the minutes of the MPC meeting released on June 20, 2025. Yet, he noted that the RBI still has other instruments in its monetary toolkit to ease the impact of NIM compression. “Some of the adverse effects on NIM can be neutralised by other monetary policy instruments available with the RBI,” he said.

Margin squeeze

In FY25, the banking sector saw a dip in net interest margins as rising deposit costs and slower loan growth took a toll. Private sector banks were more affected, with some reporting a 20–40 basis point drop in NIMs. For example, ICICI Bank’s NIM fell to 4.27% in Q4 FY25 from around 4.5% a year earlier. Axis Bank also saw its margin shrink to 3.8% from 4.02%. HDFC Bank, however, maintained stable NIMs at 3.5% year-on-year, according to reports.

Private banks continued to lead on NIMs, staying in the 4.0–4.4% range, but faced pressure from rising deposit costs and loan repricing. Their loan growth also slowed, affecting overall profitability.

Public sector banks (PSBs) had lower NIMs—typically between 2.7% and 3%—but the decline was milder. Some PSBs even posted strong profits despite margin pressure. For instance, PNB reported a NIM of 2.81% in Q4 FY25, slightly down from the previous quarter.

Large PSBs like SBI and Canara Bank expect only a modest margin dip in FY26, as lending rates gradually catch up with deposit rates. Overall, sector-wide NIMs averaged around 3.5% in H1 FY25, with further softening likely in the coming months, according to reports.

Macroeconomic cushion

Some of the optimism around offsetting the NIM squeeze stems from India’s robust macroeconomic fundamentals. Consumer price inflation has cooled dramatically, registering 3.2% in April 2025—the lowest in nearly six years. Food inflation is subdued, and core inflation remains well within the comfort range. With the RBI forecasting FY26 inflation at 3.7%, real interest rates are running too high to support growth, strengthening the case for a 50-basis-point rate cut.

Still, another concern looming in the backdrop is the shrinking interest rate differential with the U.S. Federal Reserve. As India trims its repo rate to 5.5%, the spread with U.S. rates is likely to narrow to its lowest level in recent years. This could make Indian assets less attractive to foreign investors, potentially weakening the rupee.

“Another concern is that a relatively big rate cut would mean the interest rate differential with the U.S. Fed would reduce to the lowest levels in recent times. This, ceteris paribus, can put pressure on the rupee, especially vis-à-vis the USD,” Singh said.

However, Singh downplayed this risk, arguing that any depreciation pressure would be “confined to the short run.” India’s strong external position—characterised by a stable current account, healthy forex reserves, and stable commodity prices—should cushion the currency from prolonged stress. Moreover, if the rate cut successfully boosts credit demand and growth, it could help offset both the NIM pressure on banks and concerns over the exchange rate.

Credit growth, after all, remains sluggish despite two rate cuts earlier in the year. The demand for new loans is at a seven-quarter low, and sanctioned limits remain underutilised. Corporate balance sheets are underleveraged, and private investment has yet to pick up meaningfully, despite strong government capex. By lowering the cost of funds through a front-loaded cut, the RBI hopes to nudge both borrowers and lenders into action.

“Despite two rate cuts in February and April 2025, and call money rates dipping below the repo rate and at times even below the SDF rate, credit growth has not picked up. The demand for loanable funds is lower than usual,” said Singh.

In the coming quarters, banks may need to get creative—leveraging digital outreach, cross-selling, and fee-based services—to protect their profitability. But if growth gains momentum, as the MPC hopes, the NIM sacrifice may well be worth it. As Singh summed up, “A pick-up in growth can more than offset the adverse effect of reduced interest rate differentials.”

Dr. Nagesh Kumar, Saugata Bhattacharya, Prof. Ram Singh, Dr. Rajiv Ranjan, Dr. Poonam Gupta, and RBI Governor Sanjay Malhotra were also present at the meeting.