The banking sector’s outlook has turned negative for the near term. Its margins are expected to decline because of repricing of deposits, repricing of bond books (especially for public sector banks), decline in asset quality, and risk of a slowdown in credit growth.
The Reserve Bank of India’s (RBI) cap on bank investments in liquid mutual funds is also expected to have an impact on net interest margins (NIMs). Banks have been arbitraging by borrowing from the liquidity adjustment facility (LAF) of RBI at 6.5-6.75 per cent and investing in short-term liquid mutual funds that gave them returns of 8-8.5 per cent, since short-term rates increased sharply in December 2010.
How much will NIMs fall?
According to estimates by Morgan Stanley, net interest margin (NIM) compression for public sector banks is expected to range from 40-70 basis points (bps) over the next 12 months. NIMs of private banks are not likely to get compressed as much as repricing of bond books will not affect them to the same extent.
NIM compression is likely to lead to single-digit growth in pre-provision operating profit (PPOP). This would be a drastic decline from the 40 per cent plus growth in FY11.
Reasons for margin compression
Deposit repricing: One of the main causes of NIM compression, according to a recent report from Morgan Stanley, will be the spike in funding costs. Banks raised deposit rates fairly aggressively in December 2010.
Term deposits in India have an average duration of about one year. So far higher deposit costs have not had an effect on NIMs. However, this is likely to show up from Q1FY12, as new deposits will be up to 300 bps more expensive than those being replaced.
In Q3FY11, average term deposit costs of public sector banks were broadly similar to the Q2FY11 levels. But some signs of cost of funds rising were apparent in Q4FY11.
Deposit rates unlikely to come off sharply: When loan growth started to pick up in India around FY04, banks were in a highly liquid position. Loan-to-deposit ratios were low at around 50 per cent. Banks were able to record a compounded annual growth rate (CAGR) of 30 per cent in credit growth over the next four years. Even then, with real deposit rates averaging only 1 per cent, deposit growth trailed at 20 per cent CAGR. However, banks could expand credit at a high rate by increasing their loan-to-deposit (LD) ratios.
However, the picture has now changed. Banks cannot increase their loan to deposit ratios any more as, at 75-76 per cent, they are close to the maximum, given the reserve requirements in India such as statutory loan ratio (SLR) and cash reserve ratio (CRR) stipulated by the central bank.
Therefore, banks will have to keep real deposit rates meaningfully positive if they want to maintain their credit growth targets of 20 per cent plus.
Morgan Stanley does not expect a material decline in deposit rates unless inflation comes off sharply. This implies that deposit rates will remain around the current 9 per cent over the next year (which means banks’ cost of funds will remain high). Higher deposit rates will in turn affect NIMs substantially.
Investment spread: About 25 per cent of Indian banks’ interest-earning assets are in bonds. The average duration of the bond book of public sector banks is about five years, while for private banks ranges from one-two years. Given the big asset-liability mismatch (ALM) on bond books (five-year bonds funded by one-year deposits), rate moves cause a big swing in NIMs. The bond book reprices over five years. Hence, when deposit rates are coming down, bond book spreads move up sharply, as was seen between January 2009 and August 2010. During that period, 50-60 per cent of NIM expansion at public sector banks could be attributed to higher bond spreads. However, the reverse is also true. When deposit rates rise, bond book repricing lags, causing a sharp reversal in NIMs.
Sharp slowdown in incremental credit-deposit ratio: The other factor that will hurt NIMs is the sharp decline in incremental credit-deposit ratio. On a three-month trailing basis, banks have been able to place only half of the new deposits they have raised (at elevated levels). The rest is being deployed in investments where spreads will be close to zero. If this continues, it will create further pressure on NIMs.
Deposit mix shift: The other drag on NIMs could come from a change in the deposit mix. Between FY09 and FY11, savings account deposits picked up considerably as term deposit rates were low and savers had little incentive to keep their money in long-term fixed deposits. Now, with real deposit rates turning positive, depositors may withdraw money from savings account and put them in term deposits. This will raise the funding cost of banks and affect their margins further. According to the Morgan Stanley report, public sector banks (especially SBI) will keep gaining a higher share of savings deposits, but the overall savings account pie itself is unlikely to grow much.
If the savings deposit rate is deregulated, that would also exert pressure on NIMs. RBI recently released a discussion paper on this subject which suggests that it favours deregulation of the savings deposit rate. Currently, the interest rate on savings deposit is 4 per cent. If this rate is deregulated, it could raise banks’ cost of funds and put further pressure on NIMs.
Morgan Stanley analysts expects NIM compression to lead to a slowdown in core revenue growth from 34 per cent in FY11 to 7 per cent in FY12.
Lower NIMs will also affect PPOP growth, which is expected to fall from 45 per cent in FY11 to around 4 per cent in FY12. Morgan Stanley expects the NIMs of public sector banks to get compressed by 40-70 bps in FY12. This is still higher than the previous bottom. If deposit rates remain high, margin compression could exceed this forecast.
Asset quality deterioration: Currently, the market is assuming that asset quality will remain fairly benign in FY12. However, the risk that asset quality could deteriorate is rising. With lending rates having moved up, there will be pressure on marginal borrowers. If inflation continues to stay at current levels, lending rates will remain high. Asset quality will then begin to come under pressure.
Moreover, provision levels at Indian banks remain fairly low. This implies that hits to the bottomline will be substantial, whenever credit costs rise due to rising non-performing assets.
The saving grace is that unlike at the beginning of FY09, the unseasoned loan book (loans written in the last two years) is not high. That, however, is not necessarily a cause for comfort. Had banks cleaned out their bad loans from the previous cycle, it would be fine. However, they only restructured those loans that were about to go bad. If the economy stays weak, some of those loans could turn into non-performing loans (NPLs) and banks may have to make higher provisions for them.