Banks' margins won't fall so soon

Elevated provisioning for bad loans and a slow pick-up in credit demand are larger concerns

The implementation from April 1 of a marginal cost of funds-based lending rate (MCLR) regime is unlikely to have a meaningful impact on banks’ net interest margin (NIMs) in the near term.

There is quite a difference between MCLR and banks' base rates (BRs, the benchmark for lending rates). Vishal Goyal, financials analyst at UBS, believes the 20-25 basis points (bps) difference, versus the earlier expectation of 50 bps, would limit the adverse impact on margins.

Rating agency ICRA Research agrees. “Banks’ shortest tenure overnight MCLRs (median for seven large banks) are lower by around 50 bps than their prevailing BRs. However, the one-year median MCLR is only 15-20 bps below their BR. Hence, any significant impact on NIMs is unlikely,” it wrote in a recent report on the sector.

The new lending rate regime is a structural negative for banks. For, it will reduce the time lag in their transmission of monetary policy and limit their discretionary power in loan pricing. This is because these norms will link banks’ benchmark lending rates to MCLR, which will move in line with the incremental cost of funds. Thus, the downward pressure on NIMs will intensify under this regime, as we are in a rate easing cycle.

The impact of the new mechanism, though, would further differ with the reset period chosen by a bank and the extent of asset-liability mismatch. By Reserve Bank of India (RBI) norms, the maximum reset period allowed is a year. If a bank has chosen one year, the MCLR rate will be fixed for a year.

State Bank of India has a higher asset-liability mismatch, as floating rate loans form a bigger part of its assets and fixed-rate Casa (current an savings account) deposits dominate its liabilities. Thus, analysts are not surprised by its decision to choose a year for resetting its MCLR rate. This will limit the impact on NIMs to some extent, while giving an opportunity of market share gains (in the near term) to competitors.

“We see the beginning of a new period of loan pricing competition under the MCLR system. Banks with a better-matched asset-liability can utilise their competitive advantage through reset periods; those with an asset-liability mismatch face the risk of margin compression,” says Ravi Singh, financials analyst at Ambit Capital. He believes HDFC Bank, with a lesser asset-liability mismatch, could introduce a short reset period and gain some market share.

Housing finance companies (HFCs) such as HDFC and LIC Housing Finance also stand to gain in the near term. As more banks are likely to select a one-year reset for their home loans, HFCs can offer lower rates and garner additional market share in this period.

“Banks are having operational hurdles in re-pricing home loans to tenures shorter than one year, which can be a clear advantage for all HFCs. The latter can opt for an MCLR with three months' reset, 25-35 bps cheaper compared to one-year rates,” says Jignesh Shial, banking analyst at Quant Capital. With banks forming a large chunk of their borrowings, HFCs will be in a better position to pass on the lower rates to borrowers. “We believe the lower than expected cut in home loan rates would ease the concern of pricing pressures here and be positive for HFCs,” adds Goyal of UBS.

Further, earlier expectations of companies shifting from commercial paper (CP) borrowing to bank credit could not materialise. This is because banks’ current three-month MCLR are 50-100 bps higher than the prevailing CP interest rates, by ICRA estimates.

While banks have for now managed to restrict the margin contraction, they will have to pass on the monetary easing done by RBI on April 4 at some time, sooner than later. With elevated provisioning for bad loans and a slow pick-up in credit demand, falling NIMs would be an additional concern.