Summary of this article
Private banks could see an initial NIM boost from faster loan repricing
Banks with expensive deposits or fixed-rate loans may face greater margin pressure
Investors should watch deposit costs, credit growth and asset quality after the rate hike
The Reserve Bank of India’s (RBI’s) 25 basis points (bps) repo rate hike to 5.50 per cent is likely to affect banks differently, depending on their loan mix, deposit franchise and funding costs.
Banks with more repo-linked floating-rate loans and low-cost deposits could see an initial improvement in net interest margins (NIMs). Lenders dependent on expensive deposits or fixed-rate loans could face greater pressure.
The Monetary Policy Committee (MPC) unanimously backed the hike, the first since February 2023, and shifted its stance from neutral to “calibrated tightening”. The RBI also raised its FY27 inflation forecast to 5.20 per cent from 5 per cent and growth forecast to 7.10 per cent from 6.70 per cent.
Why Private Banks Could Benefit Initially
The impact will depend on how quickly loan and deposit rates reprice.
Floating-rate loans linked to an external benchmark, usually the repo rate, can reprice faster than deposits. Term deposits, for instance, are repriced when they mature. This timing difference can temporarily support NIMs.
“In a rising interest rate scenario, not all banks take a hit in a similar fashion. When the RBI hikes repo rates, banks reprice their floating rate loans to the customers, usually within a quarter's lag. Since a majority of the floating-rate loans now are linked to an external benchmark lending rate, which is ideally the repo rate, it becomes easier for banks to reprice the rates,” said Siddharth Purohit, Fund Manager-Equities, InvestValue Capital.
He added that private sector banks have a larger share of repo-linked floating-rate loans than public sector banks, which still have a sizeable MCLR-linked book.
MCLR is the benchmark rate banks use to set interest rates on certain floating-rate loans. EBLR loans are linked to an external benchmark, usually the RBI repo rate.
Private banks with strong current account and savings account (CASA) deposits could have an additional advantage as their deposit costs may rise more slowly than loan yields.
“Large private banks with a strong CASA base and a loan book mostly linked to the repo rate are best placed. Their EBLR loans reprice within a quarter. Their CASA deposits barely move, and their term deposits reprice only as they mature. For the next two to three quarters, their yields should rise faster than their funding costs,” said Dr Arindam Banerjee, professor and program director at Master of Applied Finance & Wealth Management, SP Jain School of Global Management.
Large public sector banks with granular retail deposits could also be relatively better placed, he said.
“Large public sector banks with granular retail deposits are a close second. Their MCLR-heavy books pass on the hike more slowly, but their deposit franchise is sticky and inexpensive.”
But The NIM Benefit May Not Last
The initial margin benefit could fade as banks compete for deposits and raise deposit rates, pushing up their cost of funds.
Purohit said private banks could benefit initially from the loan and deposit repricing gap, but “as the competition for deposit mobilisation” increases, funding costs could rise and pressure NIMs.
Banerjee said investors should focus on the composition of deposit growth.
“Deposit growth, and specifically how it is made up. NIMs are an outcome of the funding mix, not a driver of it. With liquidity drained and credit still growing, the next fight is for deposits. The warning signs are a falling CASA ratio, faster growth in term deposits than in total deposits, and a rising share of certificates of deposit.”
Which Banks Could Face More Pressure
Banks dependent on high-cost deposits or fixed-rate lending could face greater pressure.
“The real pressure falls on three groups: banks that lend close to 100 per cent of what they raise in deposits, or more; small finance banks and others that depend on bulk or high-cost term deposits; lenders whose books are mostly fixed rate, such as vehicle finance, microfinance and loans inherited through NBFC mergers. For these banks, funding costs go up immediately while loan yields stay where they are,” Banerjee said.
Higher rates could also slow credit growth and eventually weigh on asset quality.
“So while private banks with high floating rates loan book tend to benefit temporarily, the rising lending rates eventually can result in a slowdown in the loan growth and asset quality pressure, so net banks don’t end up benefiting from the rising rate scenarios in the long run,” Purohit said.
Asset Quality Impact Could Take Time
Higher rates may put pressure on unsecured retail and microfinance borrowers, but any deterioration in asset quality could take several quarters to emerge.
“Asset quality lags rates. Unsecured retail loans and borrowers from microfinance institutions feel that EMI increases first. Expect any stress to show up two to three quarters after the hike, not right away,” Banerjee said.
He also expects less earnings volatility from banks’ bond portfolios under the revised investment norms.
“The bond book is less of a worry than it used to be. Under the revised investment norms, most mark-to-market movement on AFS securities goes to reserves rather than the P&L. Treasury losses will not distort reported earnings the way they did in 2022.”
What Investors Should Watch
Investors should track CASA ratios, deposit costs, the share of repo-linked loans, credit growth and asset quality.
“The key thing to watch would be the pace of credit growth. A slowdown in credit growth and margin pressure can be a double whammy for banks,” Putohit said.
A prolonged or aggressive tightening cycle could also hurt banking valuations, he said, as slower credit growth and margin pressure weigh on earnings expectations.
For Indian banks, the impact will depend on how long rates stay elevated and how quickly loan and deposit rates reprice.
Purohit also sees management changes at large banks as a potential catalyst for selective re-rating.
“More than the monetary policy, we believe now investors should watch if the new leaders who are all taking charge in some of the large banks can bring back visible changes in their operations, which can be a catalyst for re-rating in selective banks in India.”
Summing up, Banerjee said,“In this cycle, the winners are not the banks with the highest NIMs today but the ones whose cost of funds will rise the least over the next year.”
