Bank margins face multiple headwinds

While rate cuts may increase churn between banks, these may not boost credit off-take meaningfully

A telecom moment for the banking sector” was how a banking analyst with a reputed brokerage summed up the lending rate cut frenzy by banks in the past couple of days. Though the Street was expecting some cuts (30-40 basis points) in the marginal cost of funds-based lending rate (MCLR), the sharp 90-bp cut by State Bank of India (SBI) has taken many by surprise. Given that most banks have followed SBI’s lead, this could lead to a pricing war in the banking sector, akin to the one playing out in telecom, and eat into banks’ profitability. 

“Considering a low return on assets, every decline in margins is a significantly negative for PSU (public sector unit) banks. A 5-bp net interest margin (NIM) decline impacts profits by 5 per cent for PSU banks and 1-2 per cent for private banks,” said Alpesh Mehta, a banking analyst at Motilal Oswal Securities.

Even though these rate cuts could increase the churn of borrowers between banks, it may not necessarily give a big impetus to credit demand. This is because interest rate is just one of the factors influencing borrowing decisions. While corporate credit off-take is a function of supply-side factors as well as economic growth and demand trends, retail loans — particularly home loans — depend on affordability of houses.

These rate cuts could have a meaningful impact on banks’ NIMs. Assuming that MCLR is applicable only on incremental loans, NIMs could come off by 5 bps, which could pull back banks’ FY18 earnings by 4 per cent with PSU banks witnessing higher hit, estimates leading foreign brokerage CLSA.

However, some analysts believe these sharp cuts may prompt existing borrowers to shift to MCLR loans, which, in turn, will increase the NIM impact for these banks. “Larger PSU banks could witness an NIM contraction of 10-12 bps with the weaker PSUs seeing a higher impact. Large private banks could witness 8-10 bps fall in NIMs post these cuts,” estimated Aalok Shah, a banking analyst at Centrum Capital. Though bank credit is a more profitable avenue to deploy the huge sums of deposits garnered since demonetisation compared to treasury bills, the favourable rub off from this will not be much, believe analysts. 

Suresh Ganapathy, a banking analyst at Macquarie Capital, said, “We don’t see rate cuts as the panacea for recovery in growth and believe growth will continue to be a big challenge.” 

Given that banks have seen a huge flow of deposits after demonetisation, most analysts believe there could be more MCLR cuts on the way. 

“We expect banks to cut effective lending rates by 50-75 bps in the April-September slack season if the RBI injects liquidity via OMOs of Rs 2.2 lakh crore in FY18. After normalisation of withdrawals, however, we estimate the sustainable increase in bank deposits at about Rs 2 lakh crore,” said Indranil Sen Gupta, of Bank of America Merrill Lynch. 

Notwithstanding the recent weakness in banking stocks, investors have not yet started shopping. This is because banks will put up a weak show in the current quarter on most fronts — credit growth, fee income growth, margins and credit costs. Even though they can postpone recognising additional bad loans coming from loss of interest income and will have treasury gains, these will not be enough to offset the larger pressures. 

“We see downside risks to our earnings estimates across the board for both PSU and private banks due to demonetisation and are cautious on the sector,” added Ganapathy.