Sector View. How repo-linked loans will impact banks’ margins

Banks that have been grappling with rising bad loans, sluggish loan growth and weak earnings could find themselves in a tight spot. Effective October 1, all banks have to link their new floating rate loans — personal, retail, MSME — to an external benchmark. While the move has brought good tidings for borrowers — with quicker transmission of RBI’s policy rate actions — banks may be in for a bumpy ride.

While the new loan structure requires banks to re-price loans at a faster pace, there is little wiggle room on the deposit rate front. This is likely to put banks’ net interest margins (NIMs) under pressure in a downward rate cycle and lead to higher volatility in earnings. On the other hand, in a rising rate scenario, repo-linked loan structure can work in favour of banks. Margins can get a boost with quick re-pricing of loans, if banks do not increase deposit rates that aggressively.

Under pressure

In a falling rate scenario, NIM generally comes under pressure. This is because deposit rates may not fall as much as lending rates. Even if they do, they often happen in lags, leading to interim pressure on spreads (yield on advances less cost of funds). The extent of pain varies across banks, depending on the deposit base and loan mix (banks with higher proportion of floating rate loans are impacted more).

In the rate easing cycle between January 2015 and April 2016, when the repo rate fell by 125 basis points, SBI’s yield on advances fell by 55 basis points — from 10.55 per cent in March 2015 to 10 per cent in March 2016. But the bank’s cost of deposits fell by a much lower 17 basis points during this period. Hence, NIMs fell by 27 basis points during this period. Of course, there are other factors that impact a bank’s net interest income and margins, importantly bad loans.

Additional burden

The RBI’s mandate to link certain new floating rate loans to an external benchmark is an added burden for banks.

Banks normally lower lending rates when they are able to cut deposit rates and bring down their costs. But only about a fourth of deposits are in the less than one-year bucket (based on aggregate numbers put out by the RBI, though individual bank numbers may vary).

Hence, given that only small portion of deposits gets re-priced in the short term, re-pricing loans at short intervals (three-month reset suggested by the RBI under external benchmark), would hurt banks’ margins.

Banks will also have to manage interest rate volatility more actively, leading to additional administrative cost.

Importantly, they have to create a portfolio of deposits and loans with such a balanced mix across tenors that the overall asset-liability gaps are managed to reduce earnings volatility.

While banks can take short-term deposits (so that deposits get re-priced quickly) to manage NIMs, it can lead to a liquidity gap. The alternative would be to take floating rate deposits. But this has been difficult to implement.

SBI capping the downside in its repo-linked savings deposit is a case in point. In May this year, SBI had set interest rate on its savings bank deposits (for balances above ₹ 1 lakh) at 2.75 per cent below repo rate.

But in August, it decided to retain a minimum 3 per cent rate on such deposits (capping the downside).

Higher credit-deposit ratio

While most banks would face margin pressure, the extent of pain would depend on each bank’s strategy. In other words, the extent of impact will depend on the share of repo-linked loans for each bank.

That said, banks with higher credit-deposit ratio, in particular private sector banks, may face more pressure on NIMs, given the limited scope they have on lowering deposit rates. The numbers for June quarter reveal that few private banks sport a very high credit-deposit ratio of 80-100 per cent. This limits their ability to lower deposit rates aggressively.

In case of public sector banks, while they have enough cushion with lower credit-deposit ratio of 70-75 per cent, their deposit rates are already lower than that of private banks, restricting sharp cuts in deposit rates. SBI is better placed to weather the blow, given a stickier deposit base. The bank has also been the first to lower savings deposit rates--- from 3.5 per cent to 3.25 per cent for balances up to ₹1 lakh, effective November 1, 2019. This should provide some respite.

Rate volatility

While these are still early days to gauge the extent of pain, one way to assess the impact on earnings on account of holding assets and liabilities across different maturities or re-pricing dates is to look at the interest rate risk in the banking book (IRRBB), as disclosed under the Basel requirement by Indian banks.

As per SBI’s FY19 annual report, for every 100 basis points fall in interest rates, SBI’s earnings (net interest income) will fall by ₹6,014 crore; for ICICI Bank, there is an impact of ₹799 crore on net interest income. For Axis Bank, every 200 bps change in interest rates will impact earnings by ₹1,665 crore.

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