For banks, rising interest rates come with a flipside

Analysts fear that higher interest costs would significantly affect Indian small businesses, among the worst-hit during the pandemic. Demand from retail customers and corporate borrowers is expected to remain largely unscathed.

View Full Image

The last two years saw banks aggressively cutting interest rates on the back of surplus system liquidity that pushed lending rates to decadal lows. In addition, intense competition for customers was beginning to hurt margins for those involved in a price war, even as some stayed away, deciding against compromising margins.

The interest rate scenario has, however, changed since then. The Reserve Bank of India’s (RBI’s) monetary policy committee (MPC) has raised the repo rate by 90 basis points (bps) in two tranches in May and June. While RBI governor Shaktikanta Das recently said inflation—at 7.01% in June—appears to have peaked, the rate-setting committee is expected to deliver another 35-50 bps hike on 5 August. One bps is 0.01%.

“Rising rates will be positive for banks’ margins, especially in the early stage of the rising-rate cycle. We expect net interest margin (NIM) expansion of 20-30 bps in the near term, as about 77% of the loan book applies floating rates linked to external benchmarks or banks’ marginal cost of funding," Fitch Ratings said in a note on Monday.

Transmission into higher interest income for banks should therefore be procedural and swift, it said. While a consequent rise in the cost of funds as deposits get repriced would shrink the arbitrage for banks, Fitch believes that a moderate pick-up in loan growth would allow banks to take more time to raise deposit rates.

Bankers also said it would take some more time for their loan portfolios to be repriced, even as the repo rate has been hiked. Retail and small business loans are linked to an external benchmark—mostly the repo rate—that leads to immediate transmission. On the other hand, corporate loans are linked to banks’ marginal cost of funds-based lending rate (MCLR), an internal benchmark with a slower transmission rate.

Having witnessed an improvement in net interest margin (NIM) in the past few quarters, private sector lender Axis Bank believes it will be able to reach an earlier forecast of 3.7-3.8% over the next eight to 10 quarters. As of 30 June, its NIM expanded to 3.6% from 3.46% in the same period last year.

“This is business-led NIM improvement. And the direction to deliver that in addition to the four variables I spoke of was improving the quality and the composition of our liabilities franchise, which is work in progress," Puneet Sharma, chief financial officer of Axis Bank, told analysts on 25 July.

Although bankers seem to suggest there is no dip in demand for loans, especially in the mortgage segment, property sector experts said home sales have taken a hit post the rate hikes. Data from real estate services firm Anarock showed that owing to increased property prices and lending rate hikes, India’s top seven cities saw housing sales moderate by 15%, from about 99,550 units in the March quarter to about 84,930 units in the three months ended 30 June.

“If another repo rate hike takes place, home loan interest rates will enter the red zone, and we can expect at least short-term repercussions on overall housing demand," Anuj Puri, chairman of Anarock Group, said in a statement on 29 July.

On the corporate side, loan growth has picked up, a trend, if sustained, is expected to boost earnings. While there is still some undercutting among lenders to take over loans of well-rated corporates, a section of private banks are staying away from such deals.

On the flip side, there are concerns that the rising interest rate scenario could tarnish banks’ asset quality. This could emanate from loans restructured under a special RBI window during covid, especially loans to small businesses. Most banks have seen slippages from their restructured books in the June quarter, and they have factored in a few more in the coming quarters.