The weighted average term deposit rate showed an 80 basis points drop in the first nine months of FY21 while the weighted average lending rate on outstanding loans fell 62 basis points. (Photo: Mint)

Margin compression is coming for Indian banks’ books, but not yet

2 min read . Updated: 02 Mar 2021, 11:07 PM IST Aparna Iyer

Covid has led to a sharp drop in demand for credit and large accretion of deposits
Despite the fall in lending rates, the spread over deposit rates has remained largely unchanged

A bank’s core income is the difference between the interest it pays its depositors and the one it charges its borrowers. The net interest margin has been one of the key indicators of profitability and Indian lenders have seen it improve in the past one year. But this streak of improvement may come to an end soon as credit offtake picks up.

The pandemic has resulted in a sharp drop in demand for credit and a resultant large accretion of deposits on banks’ books. This, along with successive policy rate cuts, have brought down interest rates sharply on both deposits and loans. But the drop in deposit rates has been more, improving the spreads that banks earn. The weighted average term deposit rate showed an 80 basis points (bps) drop in the first nine months of FY21, while the weighted average lending rate on outstanding loans has fallen by 62 bps. One basis point is one-hundredth of a percentage point.

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Wholesale deposit rates have been on a downward spiral. Private sector banks shed high-cost deposits more than their public sector peers. Their weighted average term deposit rates showed a drop of 89 bps while those for public sector banks fell by 71 bps.

Lending rates on fresh loans have fallen more as incremental retail and small business loans have been priced over the repo rate rather than marginal cost of funds.

Then how are margins improving?

Despite the fall in lending rates, the spread over deposit rates has remained largely unchanged, as the adjoining chart shows. The reason has been that the economic environment was uncertain and risk perceptions high after the pandemic hit. Therefore, despite unprecedented surplus liquidity and various other accommodations targeted to reduce the price of credit, banks have not cut pricing on loan products. At the same time, lenders saw their low-cost current and savings account deposits grow faster than before.

Now, all this is likely to reverse. “Assuming the cyclical recovery in loan demand picks up, banks may need to raise their retail deposit rates, even as wholesale deposit rates are off the lows since January 2021. With new loans priced off the ‘repo’, a slower monetary policy move by the RBI (Reserve Bank of India) may be negative on NIM, at the margins," wrote analysts at Nomura Financial Advisory and Securities India Ltd.