Net interest margins (NIMs) of banks are expected to fall by 10-20 bps over the next two years from the current cyclical peak of 3.6 per cent in 9M FY24 driven by rising funding costs due to greater competition for deposits, normalising liquidity conditions and elevated loan growth. 

“Improvement in their operating profit/risk-weighted assets could be limited if banks continue to fund higher risk-weighted loans, such as consumer credit and loans to non-bank financial institutions, aggressively,” Fitch Ratings said in a note, also highlighting banks’ high reliance on net interest income (NII) which contributed 75 per cent of total operating income in 9M FY24.

However, there is some room for banks to lower operating and credit costs to offset the impact, driven by cost control and increasing efficiency from digitalisation and scope for impaired-loan ratios to fall further across most banks.

Thus, despite rising funding costs and compression in NIMs, which is expected to limit earnings upside over the medium term, banks’ profitability is likely to continue to improve and earnings will be resilient.

“Indian banks are likely to further reallocate their investments in government securities in excess of statutory reserve requirements towards loan growth. This will continue to offset pressure on margins in the near term, but banks’ higher risk appetite would also drive up the risk density,” Fitch said.

Proportion of loans

The proportion of loans in banking sector’s assets rose to about 63 per cent as of December 2023 from 56 per cent in FY22. The average liquidity-coverage ratio (LCR) of Fitch-rated banks normalised to 127 per cent from 139 per cent. The average LDR (loan-to-deposit ratio) of these banks jumped to 81 per cent in December 2023 from 79 per cent in FY23 and 75 per cent in FY22.

“We expect some gap between loan growth and deposit growth to persist, implying that banks with greater share of low-cost deposits will have the advantage,” Fitch said, adding that banks will have to balance the twin objectives of growth and margins, and some banks with high LDRs may have had to partly rely on wholesale deposits.

The share of low-cost deposits fell by about 490 bps from FY22 to 39 per cent of system deposits as of December 2023, driven by greater competition and the resultant rise in the cost of term deposits and a shift from low-cost deposits to term deposits.

”Nevertheless, funding would not be a significant challenge for the banks, given their reliance on local- currency deposits, and the central bank’s flexible approach towards liquidity management. Moreover, we expect funding to remain stable in light of the low reliance on certificates of deposits at the system level,” it said, adding that customer deposits accounted for 90 per cent of non-equity funding for banks.