Indian banks’ dream run could soon be over as deposit rates start catching up to lending rates

• Indian banks hit a purple patch in the December quarter, with the state-run State Bank of India reporting the highest quarterly profit in its history.
• Most banks delivered robust growth on all accounts, from net interest income to profit and asset quality improvements.
• However, that dream run could soon be over. According to analysts, rising deposit costs and a decline in asset quality due to an economic downturn could slow down the growth train.

The dream run of Indian banks could soon be over as rates on fresh deposits are starting to catch up with those of fresh loans amid increasing competition among banks to attract deposits.

The December quarter has been a stellar one for banks, with the state-run State Bank of India reporting its highest quarterly profit ever in Q3 at ₹14,205 crore. Most banks reported a further improvement in their asset quality, a healthy net profit growth and net interest income growth outpacing the increase in operating expenses.

All in all, all the listed scheduled commercial banks (SCB) reported a cumulative net profit of ₹65,532 crore in the December 2022 quarter, growing by 46% year-on-year from ₹44,915 crore in December 2021.

The pre-provisioning operating profit (PPOP) of SCBs grew 28.5% YoY to ₹1.3 lakh crore, driven by an expansion in net interest income. Analysts at CareEdge expect this momentum to continue in the near-term, but rising deposit costs and a decline in asset quality due to an economic downturn could slow down the growth train.

Explaining the robust earnings of banks, ratings agency Fitch said “Increased write-offs have been a key factor, but higher loan growth, supported by lower slippages and improved recoveries, have also played a role.”

Deposits catching up to loans, but so is the cost

Banks have been slow in increasing their deposit rates while the external benchmark-linked lending rates (EBLR) have risen immediately after the Reserve Bank of India’s repo rate hikes.

This has led to banks reporting robust net interest margins, growing at an average of 4.6% during the December quarter.

The scenario is now changing quickly, though – HDFC Bank, the largest private sector lender’s deposits grew twice as fast as those of its peers ICICI Bank and Axis Bank, at 19.9%.

However, this has also resulted in its cost of deposits increasing at a much faster pace when compared to its peers – while HDFC Bank’s cost of deposits stood at 4.6% in Q3, ICICI Bank and Axis Bank reported it at 3.65% and 3.94%, respectively.

According to data from the Reserve Bank of India, the gap in the growth of credit and deposits has also narrowed considerably from 800 basis points earlier to 580 basis points as of January 2023.

However, some leading banks are still struggling to mobilise deposits, and this could hamper their profitability going forward, according to analysts.

“Given the benign credit cycle, we believe that the ICICI Bank is currently witnessing a profitability overshoot, which is difficult to sustain. With deposit mobilisation lagging loan growth and timing differences in repricing, we believe that peak NIMs are now behind,” the HDFC Securities report said.

On the other hand, according to Emkay Global, economic uncertainties could unravel Axis Bank’s growth story and result in higher NPAs.

Other issues on the horizon, say analysts

According to the analysts at Kotak Institutional Equities, the risk of contraction in net interest margins (NIM) is increasing now, after a period of healthy performance in the calendar year 2022.

“The investment thesis of taking higher risk through tier-2 banks over tier-1 banks is getting tested after a period of healthy outperformance in calendar year 2022. The risk of NIM contraction or weaker loan growth is gaining traction,” the brokerage said in its latest report.

The brokerage maintains that while the return on equity and earnings outlook is “comfortable” even now, the scope for further re-rating looks “challenging given the backdrop of new flows”.

“We build NIM contraction into our estimates and are conservative on loan growth,” the brokerage added.

CareEdge, on the other hand, said that in the backdrop of Q3 performance, banks are poised to report robust growth for the full financial year 2023.

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