Resilience is the name of the game in the world of Indian banking, far more than red-hot growth, especially in the face of economic shocks. Despite ups and downs both global and local, Indian banks have come through relatively unscathed.
But recently there has been a shift in momentum, and the banking industry is now grappling with margin pressures due to sluggish advances growth and rising deposit costs. While the Nifty Bank had a 21% return in 2022, it's been quieter this year, with a modest 3% increase since January 2023. In comparison, the benchmark Nifty 50 has generated returns of 6.4% since the start of 2023.
Private banks have been the driving force behind the sector's growth, outpacing their PSU counterparts. Private banks’ advances reported a 40% growth in the past two years, compared to the 30% of PSU banks. However, the recent increase in interest rates has led to a slowdown in advances. As top lines see pressure, net profits are expected to benefit from higher recoveries and lower provisioning.
Slowing lending growth and rising deposits define the Indian banking sector
The pace of lending in the Indian banking sector has slowed down in Q1FY24. While the sector saw a CAGR of 4% in advances from Q1FY22 to Q4FY23, this growth dipped to 1.8% in Q1FY24.
With total advances reaching a staggering Rs 143 lakh crore, deposits amounted to Rs 184 lakh crore. The rise in interest rates has led to a decrease in lending growth while promoting an increase in the deposit base.
Rising deposits fuel lending growth for Indian banks
The growth in advances was possible due to a higher deposit base. The credit deposit (CD) ratio had been steadily increasing until Q4FY23. However, Q1FY24 saw a shift, with the CD ratio flatlining at 77.8%. Notably, PSU banks currently have a CD ratio below 75%, while most private banks are above the 80% mark. A higher CD ratio implies efficient use of the deposit base and an improved net interest income (NII).
However, the CD ratio is expected to decline due to rising deposits. Higher interest rates attract more term deposits, causing customers to shift funds from current accounts and savings accounts (CASA) to term deposits.
Margin pressure poses challenges amid rising costs
The declining CASA ratio has increased the banking sector’s cost of funds. Traditionally CASA has been the cheapest source of funds for banks. This drop in the CASA ratio is in line with interest rate hikes undertaken by the RBI since April 2022.
Indian banking sector’s CASA ratio hits nine-quarter low
From its peak of 43.4% in Q4FY22, the CASA ratio has dropped to 40.1% in Q1FY24. The total CASA deposits of Indian banks currently amount to Rs 73.7 lakh crore. This ratio is expected to drop further as interest rates are projected to peak in FY24. As the CASA ratio decreases, it will lead to higher borrowing costs, and put pressure on margins.
The drop in the CASA ratio has resulted in margins contracting by 14 bps over the past two quarters. The repricing of deposits and slowing advances will lead to a further decline in margins.
Net interest margins see moderation
The Indian banking sector has seen a CAGR of 20.3% in its NII over the past two years. This growth was led by margin expansion and an increase in advances. However, due to the rise in borrowing costs and the deceleration in advances, the NII is expected to grow at a slower pace moving forward.
NPAs decline due to higher provisions and better recovery
Non-performing assets (NPAs) have been a major concern for banks since 2014. However, recent trends have silenced critics. Over the past two years, gross NPAs of Indian banks have declined by 35%, while net NPAs have decreased by 51%. While the decline in gross NPA was led by higher recoveries and write-offs, lower Net NPA was from high provisioning.
Gross NPAs now account for 3.7% of advances in Q1FY24, while net NPAs stand at 0.9%. Major private banks report even lower figures, like HDFC Bank with a net NPA percentage of 0.3%.
PSU banks’ net NPAs decline with increased provisioning
Despite an impressive CAGR of 25% in advances over the past two years, the banking sector expects an uptick in NPAs once the growth in advances stops and interest rates start falling. This might trigger higher provisioning in the medium term.
However, most Indian banks maintain a Provision Coverage Ratio (PCR) greater than 70%, as prescribed by the RBI. This will provide a significant buffer against future NPAs. Banks have provisioned Rs 1,44,832 crore in the past four quarters, a decline of 11% YoY.
Indian banking sector’s provisions decline
While higher provisioning impacted profitability at the beginning of FY22, provisions as a percentage of net interest income was nearly 43%. However, it reduced to 17% by the end of Q1FY24. The Indian Banking sector aims to maintain a similar level of provisioning to buffer the balance sheet from future NPAs.
Lower provisions and recovery drive profitability
Increasing NII and lower provisioning are driving the Indian banking sector’s profitability. Over the past two years, profitability has surged by 2.33 times, and this trend is expected to continue, even surpassing revenue growth. The combination of lower provisioning and higher recoveries will help bottom-line growth for banks.
Banks’ profitability increases 2.3 times over eight quarters
While the recent moderation in banking sector margins and slowing advances have posed challenges for the Indian banking sector, they have also triggered a drop in Nifty Bank valuations. The P/B ratio of Nifty Bank dropped from a 52-week high of 3.2 in July 2023 to 2.8 in August 2023. However, this valuation remains higher than the historical averages of the past two years.
Going forward, banks are likely to see further margin contraction in the coming quarters, due to deposit repricing and lower loan demand. The growth in NII will also slow down, owing to lower growth in advances. Although there might be an increase in NPAs, it is expected to be partially offset by higher recoveries. Additionally, provisioning should remain at similar levels, boosting the bottom line. Indian banks are on solid footing right now - but investors should keep an eye on the segments that banks prioritize, as margin pressures rise.