The banking sector is expected to see a compression of 10-20 basis points (bps) in net interest margins (NIMs) to 3.0-3.1% this fiscal as deposit rate hikes play out (refer to Chart 1).

However, with lower credit costs providing an offsetting tailwind on account of continued benign asset quality, overall banking sector profitability should remain steady after touching a decadal high of ~1.1% last fiscal (refer to Chart 2).

Says Krishnan Sitaraman, Senior Director and Chief Ratings Officer, Crisil Ratings, “We believe NIMs for the banking sector have peaked. Competition for deposits has driven banks to hike rates since October 2022, and they could increase further given that deposit growth continues to lag credit growth. With an estimated 30-35% of deposits expected to come up for re-pricing this fiscal, at higher rates, and the shift from current and savings deposits to term deposits continuing, overall deposit costs will rise this fiscal. And given that most of the re-pricing on the assets side has already been done, the NIM gains seen last fiscal will partly reverse.”

The expectation of NIM compression is in contrast to fiscal 2023, which is estimated to have seen an expansion of ~30 bps to 3.2% from 2.9% in fiscal 2022. This was due to the differential pace of rate changes between the assets side and the liabilities side for most of fiscal 2023. On the assets side, with ~80% of advances being on floating interest rates¹, interest income rose sharply as repo rates started rising. On the liabilities side, deposits are predominantly at a fixed cost, resulting in any higher interest rate being applicable only to the incremental deposits raised and renewals.

Banks chose to raise deposit rates well after lending rates rose even though the pace of deposit growth was slower than credit growth last fiscal, opting instead to utilise their excess liquidity.

Additionally, the Reserve Bank of India has now hit pause on repo rate hike for the time being, which would limit the ability of banks to further increase lending rates on loans linked to external benchmarks. Of course, the second-order effect of a rise in cost of funds on MCLR² would, in turn, have a benefit on the assets side with somewhat higher lending rates. But the extent of that will be relatively less.

Says Subha Sri Narayanan, Director, Crisil Ratings, “While NIMs are expected to compress this fiscal, what will provide an offset and support overall bank profitability is a reduction in credit costs. Gross non-performing assets (GNPAs) have already hit a decadal low of ~3.9% as on March 2023, and leading indicators such as the quality of the corporate loan portfolio and the Crisil Ratings credit ratio³ point to a further reduction in GNPAs this fiscal. Further, provisioning coverage ratio is at an all-time high of ~75% for the banking system. Therefore, credit costs, which had started to correct in fiscal 2021 from ~1.8% on average between fiscals 2016 and 2020, are estimated to have dropped to 0.7% in fiscal 2023, and are 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, given that rates are not expected to rise materially from here.

Hence, while NIMs will shrink this fiscal, overall banking sector profitability should remain at ~1.1% after having continuously improved for the past 3 fiscals.

¹ About half of this is linked to external benchmarks such as repo, and re-prices rapidly
² Marginal cost of funds based lending rate
³ Crisil Ratings credit ratio (ratio of rating upgrades to downgrades) was at 2.19 times in the second half of fiscal 2023