Nearly ₹6-lakh crore of excess liquidity has almost dried in about six months. Benchmark rate or repo has risen from four per cent until May 4, 2022, has risen to 5.9 per cent, a level last seen in 2018. There may be another 50–75 basis points (bps) hike to stomach, going by the projections. Can banks withstand this jolt? What will be the impact on Net Interest Margins (NIMs) with touched a multi-quarter high in the gone by September FY23 quarter? NIM is usually guided by three factors: the product mix of the bank, ability to price risk and ability to pass on costs. There are signs to suggest that each of these factors may come under pressure for banks soon. For investors, this may be an indicator to set more realistic expectations from bank stocks, going ahead.

Trouble factors

NIM derives its value from what can be charged to a borrower on a loan and how much of a bank’s cost, including that interest paid on deposits, can be absorbed. At present, nearly 70 per cent of loan assets are benchmarked on floating rate. So when rates go up, which is the direction presently, it can be transmitted to the customers without delay. On the other hand, liabilities (deposits) are still on a fixed rate tenure. Therefore, even if the repo has increased by 190 bps so far, the cost of deposits for banks until early November rose by just about 100 basis points. Also, when repo increases, the existing and fresh loans get repriced without a lag, whereas the existing stock of deposits get repriced only when they come up for renewal and it’s largely the new deposits that reflect the higher rates. This explains the mismatch in transmission of rate hikes and the gap has ensured that banks don’t suffer margin pressures just yet.

However, banks cannot endlessly play on this mismatch. Repricing of liabilities or deposits usually happens with a 6-9 month lag. Considering that rate hikes began in May, the upcoming December quarter results should capture the increase in deposit costs. From the March FY23 quarter, investors should expect the impact to be more pronounced and the advantage of having low cost of funds — which was a major factor in earnings re-rating of banks in the last year — may narrow or vanish in FY24.

Simply put, the NIM expansion party for banks is nearing its end. But the extent of pressure on NIMs is dependent on how each bank is affected by the following aspects.

Product mix: While demand in retail loans was buoyant and that continued to support NIMs even in Q2, it’s pertinent to note that the growth lately has been driven by high yielding products such as gold loans, credit cards, unsecured personal loans and vehicle finance — and not much by home loans. Gold loans and unsecured loans carry higher risk vis-a-vis the secured ones and offer higher yields. But this is a segment that is tends to be rate sensitive and even a 20 bps differential could sway the needle. Until now, the propensity to borrow at elevated cost was high due to pent-up demand. With the first signs of moderation becoming particularly visible on the mortgages or home loans segment, it is a matter of time that the trend catches up across retail products. In such a case, banks would be more comfortable to roll out secured products rather than unsecured and this will alter the NIM composition. Typically, banks maintain 50:50 split between secured and unsecured retail loans, though in case of ICICI Bank, Axis Bank and SBI the proportion is more in favour secured products.

Ability to price risk: Until about six months ago, it was a borrowers’ market. Someone with a credit score of 800 or above would be able to bargain for a good rate. Today, with liquidity playing a determining factor, that’s not so much the case as excess liquidity has dried up. Yet, banks have to focus on loan growth and they have two options — lower the risk premium a bit to make the composite lending rate attractive or stay away from risky customers and cater only to prime and above customer segment.

Either option will impact NIMs. When risk premiums are lowered, the rate of interest will be straightaway impacted. On the other hand, if a bank chooses to cater only to prime-plus segments, the market opportunities may shrink. Contraction in growth would have an indirect bearing on NIMs.

Ability to pass on cost: This is the derivate of the customer pool a bank wants to cater to and how much bandwidth it has in terms of pricing risks. Another underlying factor is the growth rate it targets commensurate to the liquidity. As long as banks had access to cheap funds, these weren’t constraining factors. But when liquidity is an issue and banks choose to maintain growth at the current levels, then they may want to do so without causing much dent to their quality of loan book. For instance, if the objective is to maintain a 50:50 mix of secured and unsecured loans and have an average credit score of 720-plus, this would put downward pressure on NIMs.

Here’s a word of caution. If banks don’t see much disturbance on their profitability, going forward, scrutinise their loan portfolio mix and the segment of customers they cater to. Typically if banks choose to stay with unsecured products and borrowers with not-so-good credit score, they would have a greater pricing flexibility and better profitability. But the risks maybe slowly building in their balance sheets. On the other hand, banks with a higher share or increase in secured loans and/or a larger pool of ‘prime and above’ borrowers will be susceptible to a decline in NIMs.

Who will be impacted?

Let’s look at this from two perspectives — private banks vs public sector banks (PSBs) and banks with large balance sheets vs relatively small banks.

The average NIM for private banks is a little over four per cent now while for Bandhan and IDFC First Bank it’s upwards of 5 per cent. To an extent, this indicates the underlying risks in the balance sheet. With higher share of unsecured loans, these banks have historically operated at high margins. At times like these, , a further improvement in NIM or even sustaining it at the same level is a red flag of some sort.

Exposure of microfinance (MFI) loans is a key factor driving NIMs for private banks and this is particularly prevalent in banks such as RBL Bank and IndusInd bank in addition to Bandhan and IDFC First. While RBL and Indusind may continue to operate above four per cent NIMs (though their share of unsecured loans is relatively lower compared to Bandhan and IDFC First), investors should watch out whether RBL Bank and IndusInd Bank  jack up their exposure to the MFI space to play the profitability or yield game. Until now that’s not been the case, but if it changes, then it’s a warning sign.

Historically, private banks have enjoyed better NIMs compared to PSBs and hence when there is a risk to profitability, PSBs take a bigger beating. But this time it may not be so. On an average, cost of deposits of PSBs is at least 50–70 bps lower than private banks’. Therefore, even as deposit rates increase, the hit on PSBs may be small compared to private banks. Secondly, if banks choose to recalibrate their product mix more in favour of secured products such as home loans, car loans and gold loans where the rate offered by PSBs is more competitive (invariably lower) than private banks, PSBs, which already have a higher share of secured loans, may not cede much NIMs. But that said, NIMs of PSBs is 90–100 bps lower than private banks’. Therefore, while they may not face much profitability disturbances this time around, the room for improvement is restricted.

Likewise, larger banks such as SBI, ICICI Bank, HDFC Bank and Axis Bank, which have established themselves strongly in the retail market, are well-equipped to pass on and maintain cost equilibrium even if there are further repo rate hikes. These banks haven’t seen a significant pressure on their yields so far and hence if they must absorb some cost pressures to keep the demand undisturbed, they have a room of 10-30 basis points. 

Smaller names such as YES Bank, RBL Bank and Federal Bank may be more sensitive to rate hikes, and this is reflecting on yield on assets. Growth may come at a cost, and they may have to absorb a reasonable part of rate hikes. Therefore, yield compression of 50-70 bps seems likely, which may translate to at least 30 bps reduction in NIM.

What next?

How banks manage and re-balance their NIM is a good sign of what to expect in the next three to four in terms of asset quality and the product mix of their choice and comfort years. Therefore, while NIM movement is not an alarm bell just yet, it sets the tone for the long-term course of banking stocks. Given how they have rallied in the last two years, now may be a good time to partially book profit across banking stocks and gain from the rally.?

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