Banks are now facing margin pressures

Banks are now facing margin pressures

Banking stocks have declined by 6% in the past three trading sessions, even while the broad markets have been more or less flat. This is because of concerns that the banking industry would face pressure on net interest margins on the back of rising deposit rates.

The two largest banks in the country, State Bank of India and ICICI Bank Ltd, raised deposit rates earlier this month. Their shares have fallen at a faster pace of 7% and 8%, respectively, in the past three trading sessions.

Investors also seem to be concerned about RBI governor’s statement last Friday that banks ought to operate on lower margins by increasing deposit rates and lowering lending rates. According to him, this will lead to an increase in savings rate and lead to double-digit inclusive growth in the economy. This statement almost coincided with the decision of some banks to raise deposit rates, accentuating investors’ fears.

There’s little doubt that margins would be under pressure in the near term, since lending rates are typically raised with a lag effect. According to a report by Macquarie Research, “While lending rates (base rate/PLR) have moved up by 50-75 bps (basis points), retail deposit rates have already moved up by 150-200 bps since 10 June and wholesale deposit rates have moved up by 300 bps. We don’t think banks have sufficient pricing power as already evident by asymmetric rate increases. Since deposits re-price with a lag in India, we expect margin pressure to be more evident beginning from 3Q FY11 onwards." One bp is one-hundredth of a percentage point.

It adds that due to a widening gap between loan growth (23%) and deposit growth (16%), it’s likely that banks will scramble for deposits, which will lead to a deposit rate war. Given the experience in the past six months, when lending rates haven’t kept pace, the pressure on margins should only increase.

While some of this is reflected in the share price of banking stocks, the correction in the past few days seems to be relatively low. Note that prior to the correction in the past three trading sessions, the Bank Nifty index had outperformed the Nifty index by about 60% since early March 2009. After the correction, the level of outperformance has come down to 50%.

Valuations continue to be high, with private sector banks trading at an average price-book valuation of 3.3 times based on the FY11 estimates of Macquarie. Public sector ones trade at an average price-book of two times. Banking shares may correct more when the margin pressures start getting reflected in their quarterly results.