Credit costs play a critical profitability factor for Indian banks, as evidenced during the last major asset quality downturn, and will remain a key monitorable for the foreseeable future, Saswata Guha, Senior Director, Financial Institutions (Banks), Fitch Ratings, tells businessline in an interaction. He says 2025 will be a critical year for unsecured retail loans, and potentially a litmus test of banks’ underwriting capabilities, particularly their claims of lending primarily to salaried borrowers, and individuals with stable cash flows. Edited excerpts:

What is your outlook on banks’ profitability?

We anticipate banks’ profitability to moderate post FY25 due to net interest margin (NIM) normalisation, and an uptick in credit costs. Our projections include a 10 basis points (bps) NIM contraction for the sector in FY25 and FY26 each, with impact varying across individual banks. Funding cost is the key driver, although a better alignment of credit growth and deposit growth should help reduce some pressure on funding cost. Banks with strong franchises may be able to intermittently counter these pressures through higher non-interest income or cost efficiencies, but not perpetually if loan growth remains moderate. Moreover, Indian banks do not enjoy much pricing power due to the stiff competition which limits the potential for NIM. It is currently at a historical high, compared to the long-term average of around 3 per cent, which implies that reversion towards mean will likely continue. This makes asset quality, and thus credit costs a critical profitability factor, as evidenced during the last major asset quality downturn. This is a key monitorable for the foreseeable future from our perspective.

Loans in unsecured segments has started showing higher defaults...

Recent years have seen a predominance of retail lending, including unsecured loans. Risk levels vary within this category. For example, microfinance loans are arguably the riskiest experiencing significant delinquencies, followed by small unsecured loans typically ranging between ₹50,000-₹60,000, or lower. These smaller loans are primarily used for consumption rather than asset creation, and generally avoided by large banks due to their inherent risk. However, these banks could still be indirectly exposed through funding NBFCs that on-lend to such borrowers. RBI’s latest report highlights that this segment is levered, driven by consumption, with most borrowers having multiple loans. This creates a risk of stress potentially spreading to secured asset classes. Additionally, stress could manifest through financial markets, which has seen a significant rise in retail participation, coinciding with high growth in unsecured personal loans. We anticipate that 2025 will be a critical year for unsecured retail loans, and potentially a litmus test of banks’ underwriting capabilities, particularly their claims of lending primarily to salaried borrowers, and individuals with stable cash flows.

How much of a part is GDP growth slowdown playing in slower credit growth?

Credit growth and economic growth are traditionally interlinked, with each influencing the other. However, the current slower loan growth is primarily due to banks trying to manage or reduce their loan-to-deposit ratios, as deposit growth has lagged behind loan growth in recent years. Additionally, increased risk weights have compelled banks to slow lending to NBFCs and (unsecured) retail loans, which has also contributed to the slowdown in lending. We believe that retail loans will continue to experience above-average growth, with banks focusing on secured asset classes such as housing loans and auto loans. Auto loans may soften in the near-term, but housing loan growth should continue to benefit from India’s low housing penetration rate, and lower risk weighting. Banks are likely to maintain a cautious stance towards SMEs, partly due to slowdown in specific sectors.

Will deposit competition remain intense in the current year. Some small banks are offering up to 9 per cent on savings account?

This has always been the case, reminiscent of a quote that, in banking, assets are liabilities and liabilities are assets. Funding is a bank’s raw material, influencing both pricing and risk appetite. Banks offering substantially higher savings deposit rates than competitors are often compelled to deploy funds in riskier assets to maintain profitability thresholds. Given the persistent lag of deposit growth behind credit growth, competition for deposits is inevitable. Our analysis reveals that deposits have grown by only about 9.4 per cent over the last decade. The key differentiator has been loan growth, which was notably low during the last asset quality downturn. This not only helped banks contain their LDRs, but actually lower them during that period.

Published on January 24, 2025