Will banks’ margins dip if interest rates ease?
4 min read 23 Apr 2023, 10:01 PM IST- For the top five lenders, net interest margins increased throughout 2022-23. This is not surprising: research shows that banks’ profitability improves when interest rates rise
PremiumStrong financial results posted by Indian banks have led to much optimism on their earnings prospects. For the top five lenders, net interest margins increased throughout 2022-23. This is not surprising: research shows that banks’ profitability improves when interest rates rise. But what next?
Net interest margins (NIM) reflect the difference between what banks earn from the interest rates on loans and the interest rates they pay on deposits. Indeed, this gap expands when interest rates are hiked, since existing loans are repriced up and fresh ones are given at higher rates, while the cost of current and savings account deposits stays low. But although that’s typical for monetary policy tightening cycles, this time was especially favourable for two reasons.
First, since September 2019, banks have been required to lend to the retail sector and micro, small and medium enterprises at interest rates linked to an external benchmark (such as the repo rate). By December 2022, such benchmark-linked loans formed 48% of outstanding floating-rate rupee loans. This effectively pushes up NIM by allowing better transmission of repo rate hikes to lending rates. Second, bad loans are the lowest in years, thus removing the risk-aversion to lending that comes when banks have a heap of non-performing assets to provide for. But as central banks around the world prepare to unwind monetary tightening, what does it mean for banks? If rate hikes improve bank margins, will a pause in tightening—and eventual easing—reduce margins? That would depend on the pricing power of banks, their liability structure and overall economic growth.
Repricing Power
A pause in monetary tightening, such as now, is useful for banks to assess their ability to reprice deposits and loans. Traditionally, deposits have been the mainstay for banks, with depositors being passive price-takers. But deposit holders are more rate-sensitive nowadays, posing a threat to profitability gains. To start with, there is a conscious shift towards term deposits: the big five banks saw strong growth in term deposits in 2022-23. In response, banks have had to jack up interest rates to attract deposits. Scaling them back to pre-2022 levels may not be easy.
Lending rates respond faster to policy changes, so they are likely to stabilize or decline in sync with policy rates. However, the key metric here is credit growth, which has remained robust so far despite rate increases. As long as banks are able to make fresh loans at the same or even lower rates, the gain in volumes should compensate for margin compression to a large extent.
Customizing Strategy
The strategy of hedging against a potential decline in interest rates by holding longer-duration assets cannot be applied uniformly across all banks. For instance, the maturity profile of assets held by private banks (PVBs) has consistently differed from public sector banks (PSBs) over the past few years. PVBs hold a higher share of very short-term investments and loans, while PSBs hold relatively more of loans with over three-year maturity. A possible explanation is that liquid short-term investments are useful given the flight-prone nature of PVB deposits.
Reserve Bank of India data shows that 61.3% of PVB deposits were uninsured in September 2022, compared to 45.9% for PSBs. Around 34% of PVB deposits were owned by corporations in March 2022, compared to 12% for PSBs. By ensuring liquidity, PVBs achieve stability and therefore solvency. This strategy may not be optimal for, say, a large PSB.
Non-interest Income
When interest rates decline, bank margins tighten. But non-interest income—such as fee-based earnings and capital gains on investments—may offset this squeeze. By how much and for how long will depend on other factors.
For instance, the easing cycle from January 2015 to August 2017 boosted non-interest income for three financial years, but the impact of the steep rate cut cycle from April 2019 to May 2020 dried up quickly because of the pandemic.
Easing monetary policy does not cause interest margins to decline, because the easing itself is in response to an economic situation. What it does is stimulate growth and make credit available to more borrowers, setting up a virtuous cycle of credit and growth that adds to bank profitability. Assuming, of course, that growth responds positively to monetary easing. We will know in the coming months if this holds for India.
The author is an independent writer in economics and finance.
