Marginal pressure on banks next fiscal, net interest margin may fall: Fitch

Banks will face margin pressure next fiscal as they increase the deposit rates to attract funds to support sustained high loan growth, and the same will fall by 10 basis points to 3.45 per cent, a global rating agency said on Monday.

"We expect the domestic banking sector's average net interest margin to slightly contract by about 10 bps (basis points) in FY24 to 3.45 per cent, following a 15 bps increase in FY23 to 3.55 per cent, in a base case scenario, but remain well above that during FY17-FY22 average of 3.1 per cent," Fitch Ratings said in a report.

However, the 10 bps likely reduction in margin is unlikely to affect banks' profitability in the near term. Higher fee income -- stemming from higher loan growth -- and a revival in treasury gains should broadly counterbalance the twin pressures of higher credit costs and funding costs in FY24, while supporting capitalisation.

This contraction is consistent with the lagged normalisation in deposit rates, although banks should be able to offset some of the impact as they gradually pass-through policy rate hikes to corporate loans, which are typically slower to reprice than retail and SME loans, it added.

However, loan growth continuing to outstrip deposit growth is a potential risk. NIMs (Net Interest Margins) could face greater pressures if banks are forced to increase deposit rates further and turn to wholesale funding, for which costs are rising.

"The risks may be potentially pronounced if higher interest rates are unable to meaningfully moderate credit demand and increase deposit inflows as we expect under our base case," the report warned.

The system wide loan growth averaged at 17.5 per cent in the first half of FY23, with the trend continuing in December, compared to the agency's full-year estimate of 13 per cent for FY23. This is partly driven by pent-up credit demand and normalisation of excess savings built up during the pandemic, as well as corporate borrowers migrating from the local bond markets towards banks given the significant hardening in bond yields.

Banks will likely enjoy some pricing flexibility due to this shift, but competition among them for market share will eventually limit their ability to pass on the increase in funding costs to borrowers.

The expansion in margins in recent years to 3.5 per cent in H1FY23 from 2.9 per cent in FY19 is due to a decline in funding costs driven by a sustained period of low credit demand and high liquidity, rather than higher loan pricing.

Banks' increased focus on higher-yielding segments, like unsecured personal loans, credit cards and consumer durable loans, may have helped somewhat, but the steady increase in the sector's loan-to-deposit ratio to 75 per cent by end-December, from 71 per cent at FY22 led to an accelerated transmission of the central bank's 225 bps rate hikes in 2022 to deposit rates since H1FY23, pushing up banks' cost of funds.

With a significant share of banks' loan books in safer but lower-yielding segments, such as housing loans, project financing especially roads, non-banks and guaranteed credit to small businesses, passing through increases in funding costs will be progressively challenging despite floating interest rates on 93 per cent of loans at FY22.