Interest margins of banks at 12-yr high; cost of funds fell 50 bps in FY21

Banks continue to reap the ga­ins of Reserve Bank of India’s (RBI’s) cuts to the repo rate in recent years. Their interest margins – spread between cost of funds and lending rate – reached a 12-year high of 375 basis points (bps) in financial year 2020-21 (FY21) as the decline in the cost of funds exceeded the softening in lending rates.

The combined interest income of 31 listed banks in the Business Standard sample was down 0.6 per cent in FY21 while their interest expenses – interest paid to depositors – was down 8.5 per cent last fiscal leading to an expansion in their interest margins.

The data suggests that margin expansion is a long-term story for banks. In the last five years, the banks’ interest margin has risen by 59 bps from 3.17 per cent in FY16 to 3.75 per cent last fiscal. One basis point is one-hundredth of a per cent. (See the adjoining charts)

Private sector banks such as HDFC Bank, ICICI Bank, and Axis Banks have even higher margins. Their interest margins increased to 423 bps in FY21 from 412 bps a year ago. Public sector banks (PSBs), meanwhile, had lower margins of 349 bps in FY21, up from 306 bps a year ago.

Analysts attribute the margin expansion to the wedge between RBI’s repo rate and the lending rate in the market. “The spread between repo rate and benchmark corporate lending rate is now at an all-time high of nearly 300 bps. As a result, while there has been a sharp cut in banks’ cost of funds, their lending rates have declined only marginally in recent years. This has expanded the interest margins for banks,” says Shailendra Kumar, chief investment officer at Narnolia Securities.

Banks’ average cost of funds – the interest that they pay to borrowers — was down nearly 50 bps in FY21 to 4.48 per cent from 4.97 per cent a year ago. In the same period, the yield on their advances and investments was down by only 19 bps to 8.23 per cent.

In the last five years, the average cost of funds has declined by 157 bps from 6.06 per cent in FY16. In the same period, the yield on their advances and investment only declined by 99 bps.

Analysts, however, say banks have not been able to fully exploit higher margins due to a slump in credit growth. “The spread on advances and commercial loans is even higher at close to 500 bps, but banks are investing nearly 70-80 per cent of their incremental funds in low-yielding assets such as government bonds and liquid funds due to lack of credit demand from corporates and retail segments,” says Dhananjay Sinha, managing director and chief strategist at JM Finance Institutional Equity.

Banks’ combined advances rose just 5.7 per cent in FY21, growing at the slowest pace in at least 12 years. The advances were up 10.3 per cent in FY20. In comparison, the deposits were up by 11.8 per cent last fiscal and banks’ investment in bonds and liquid assets were up by 17.3 per cent.

Analysts expect a decline in margins going forward. “The interest spread in the banking industry is at the peak and it could decline from here on as costs have bottomed out. This could translate into lower earnings for banks in FY22,” says Dhananjay.

Others also see banks’ earnings coming under pressure from a potential rate hike by RBI due to a steady rise in inflation. “A rate hike by RBI will lead to immediate rise in banks’ cost of funds, but it could have only a marginal rise in their lending rate due to an already high spread between repo and corporate bond yield. This will mean lower margins for banks,” says Kumar.

Banks need a sustained uptick in credit growth, especially corporate credit, to absorb the potential decline in margins and still report higher profitability.