In the midst of global banks trimming costs and battling high interest rates, the Indian banking sector has held steady. Morgan Stanley recently ranked India as ‘overweight’ among emerging economies, with the financial sector a key driver for growth. The overall banking sector has stayed resilient even in the post-Covid period. However, Nifty Private Banks have underperformed the Nifty PSU Banks by 3.5% in the past six months. 

Private banks like HDFC Bank and Axis Bank have shown a decline in QoQ profits, while IndusInd Bank and ICICI Bank saw profit margins moderate. These private banks are grappling with a lower CASA ratio and higher cost of funds. Their net interest margins have flattened out, and show signs of decline. In response, the banks have increased loan recoveries. However, a challenge lies ahead – if interest rates drop further, there's a risk of rising defaults from borrowers. 

Credit growth declining amid rising interest rates

The robust credit growth witnessed in FY23 has begun to ease in Q1FY24. Credit expansion, which peaked in Q2FY23, is now showing signs of decline. One major reason for this decline is the rise in interest rates, resulting in a surging deposit base, and fewer loans being taken out. 

According to an RBI report, the Indian banking sector’s credit grew by 15% in FY23, while deposits increased by 9.6%. Private banks have outpaced the industry with higher growth rates.

Private banks’ YoY deposit growth outpaces advances in Q1FY24

Even with higher interest rates, the seven large private banks saw advances rise (HDFC Bank, Axis Bank, ICICI Bank, IndusInd Bank, Yes Bank, Kotak Mahindra Bank and Federal Bank),  growing by 17.7% in Q1FY24. This growth was primarily from micro, small and medium industries (MSME), personal loans, credit cards, and auto loans. Axis Bank and IndusInd Bank excelled with credit growth rates of 22.5% and 21.5% respectively in Q1FY24, beating the industry averages by huge margins.

The higher deposit base has resulted in a fall in the credit-to-deposit (CD) ratio for banks. Except for Axis Bank and IndusInd Bank, other major players saw their CD ratios decline. 

Yes Bank relies heavily on deposits for advances growth

Maintaining a high CD ratio is risky as banks are dependent on the deposit base to fund credit expansion, rather than resorting to bonds, equity issuance, or accruals. Yes Bank and Axis Bank, with CD ratios of 91%, face the risk of asset-liability mismatch (ALM) if not handled properly. 

This also leaves little room for growth unless these banks raise more deposits. It's worth noting that a part of Yes Bank's advances is funded by bond issuances. However, a decrease in the CD ratio leads to margin compression.

Q1 sees moderation in net interest margins for most private banks

Most private banks saw a moderation in net interest margins in Q1FY24, averaging a 10 bps point reduction. This trend breaks the margin expansion cycle we have seen till now

Private Bank’s NIM contracts due to increase in cost of funds

The higher interest rates have pushed the banks to choose between credit growth and margin expansion. If they increase lending rates in tandem with the increase in deposit rates, banks will see a drop in credit growth. The public sector banks have not increased their lending rates aggressively, which has forced private banks to keep their lending rates on the lower side.

Private banks, on average, saw only a 11 bps increase in yield on advances (lending rates), while the cost of funds (deposits) increased by 30 bps QoQ. The uneven increase between the yield on advances and the cost of funds is leading to margin contraction. Yes Bank and Axis Bank, which are highly dependent on deposits for credit growth will see the maximum impact.

Two major reasons for the increase in the cost of funds are the decline in current and savings accounts (CASA) and the increase in term deposits. CASA is a low-cost fund for banks and has been a major reason for margin improvement in the past year.

Private banks’ CASA ratio dropped in Q1FY24

However, the recent deposit growth was from higher retail deposits, which resulted in CASA deposit share falling by around 200 bps to 42% for private banks. 

Banks like Kotak Mahindra Bank introduced products like ‘ActivMoney’, which acts as a mid-point offering between CASA and retail term deposits. Under this product, customers get 7% on a six-month FD and the corresponding savings account rate if they choose an early withdrawal. This increases customer affinity for savings accounts.  For a bank with savings account costs averaging around 3.6% to 3.7% and a term deposit costs between 7% and 7.3%, ActivMoney brings this cost down to around 5%-5.3%.

Strong credit growth in FY23 boosts net interest income 

Private banks reported higher net interest income (NII) owing to strong credit growth in FY23. Credit offtake surged by over 18% during this period, coupled with a margin expansion of 30 to 40 bps across private banks. ICICI Bank and Axis Bank saw their NIIs rise by 38% and 27% respectively. 

ICICI Bank’s Q1FY24 NII increased by 38% YoY

Banks have also seen growth in fee and non-interest income. In Q1FY24, non-interest income contributed a 35%-45% increment on top of the NII. Fee income has been a stable source of revenue for most private banks. HDFC Bank and Yes Bank, for instance, compensated for their comparatively lower NII growth with non-interest income growth rates of 44% and 46% respectively.

NPAs rise as interest rates drop and credit growth slows

The continuous provisioning and lower credit growth (average below 10%) from FY16 to FY21 have resulted in banks taming their gross NPAs. Currently, net NPAs (Gross NPAs post provisioning) are at their lowest levels in a decade. HDFC Bank, for instance, has a net NPA of 0.3% If the agricultural segment is excluded, the net NPA drops to 0.23%. Agricultural loans, driven by seasonality, do not perfectly align with the NPA recognition criteria.

Also, private banks have cautiously increased provisioning while maintaining profitability. This has driven the provision coverage ratio beyond 75%, placing private banks in a comfortable position to absorb higher NPAs and increase provisioning as necessary.

HDFC Bank leads industry with lowest net NPA%

In most cases, lower interest rates trigger credit growth. As credit growth slows and interest rates start to drop, NPAs tend to increase. The reasoning behind it is that the lower interest rates take out the incentive for customers to pay older loans (which have higher interest rates). 

As credit growth slows, the increase in NPAs will start looking significant. If credit growth slows down below 10% from the current 17%-18% levels, and interest rates decrease by around 200-250 bps, gross NPA levels might increase by 150-175 bps. 

Recoveries and write-backs aid lower provisioning

Banks have benefited from higher provisioning in the past, as recoveries are reducing the need for new provisions. The decrease in provisioning has improved banks’ profitability. For instance, HDFC Bank saw a write-back of excess provisions totaling Rs 2,227 crore in Q1FY24. This has effectively countered the increase in provisioning, contributing to higher profitability. The trend of recoveries and write-backs is projected to persist throughout FY24. However, the RBI’s new framework around expected credit loss (ECL) will increase provisioning for banks. 

Private banks’ profitability increases on the back of lower provisioning

The new ECL framework will add an additional provisioning of Rs 1,00,000 crore for banks, according to initial estimates. Once implemented, this might eat away the banking sector’s profitability for a few quarters. 

With the threat of ECL, margin compression, and an expected increase in NPAs, banks are on the defensive. This could slow down banks’ profitability in the coming quarters, particularly as credit growth starts to taper. However, the strong capital buffers and high provision coverage ratios will act as an advantage. Despite this, banks are poised to progress with a more cautious approach, taking valuable lessons from the past.