All good things come to an end, and that’s also true of India’s banking boom. After stellar growth in 2023, the Indian banking sector is seeing signs of moderation. While the Indian economy is projected to grow by around 7.3% in FY24, a significant portion of domestic consumption has been debt-driven. The banking sector’s credit growth hit roughly 16% in 9MFY23, outpacing the overall economic growth rate. 

Meanwhile, deposit growth lagged slightly at 13%, indicating a surge in consumer spending. This has placed stress on the banking system as loans outpace deposits, and even the Reserve Bank of India's (RBI) higher interest rates have struggled to tame the cash outflow from banks.

The banking stock rally in 2023, which was led by robust credit growth, saw a drop in January 2024 due to stagnant deposit growth. A 4.4% drop in the Nifty Bank index and a 5.1% fall in Nifty Private Bank over the past month indicates that the roaring good times may have paused for the time being. A key driver of this underperformance was the decline in HDFC Bank’s stock price following its Q3FY24 results. According to HDFC Bank CFO Srinivasan Vaidyanathan, “The banking sector is facing liquidity issues as RBI has been putting liquidity constraints to curtail money supply, rather than increasing interest rates. This has resulted in a liquidity crunch for us to fund credit growth”.

Many banks are facing liquidity concerns as they have breached the optimal credit-to-deposit ratio (70%). Axis Bank CEO Amitabh Chaudhry said, “If the RBI were to set a specific number for banks regarding the credit deposit ratio, every bank would have to reassess their balance sheets.”

However, it's not all bleak for the sector, which has benefited from higher fee income and writebacks during the quarter. Still, the repricing of term deposits at higher interest rates is expected to elevate the cost of funds and squeeze margins further. 

Credit growth stays high despite higher interest rates

The RBI is tasked with regulating the flow of money in the system. High interest rates as currently implemented by the RBI are meant to encourage savings and discourage borrowing, but so far banks continue to see robust credit growth. 

The top seven private banks (HDFC, ICICI, Axis, IndusInd, Yes Bank, Federal Bank and Kotak Mahindra) have reported a 4.3% QoQ increase in credit, while deposit growth lagged at 2.8%. 

Corporate credit growth has slowed as many large firms postponed capex plans due to higher interest rates. The government primarily drove capex spending in 2023. For instance, Axis Bank’s corporate loan book grew by 13% YoY, while its retail loan book increased by 27% YoY. 

Major banks see faster loan (advance) growth compared to deposits

Most of the credit growth has come from the retail segment, particularly vehicle and personal loans. Retail grew faster as the higher interest rates from NBFCs shifted consumers to larger banks with lower rates.

As a result, ICICI Bank’s personal and credit card loans grew by 37.3% and 39.5% YoY, respectively. IndusInd Bank reported a 20% YoY increase in vehicle finance for Q3FY24. HDFC Bank, however, has been an exception and reported a 6.7% QoQ growth in its commercial and rural banking segments.

Slower deposit growth a worry for private banks

The surging credit growth has begun to deplete the deposit bases, pushing many banks to a credit-deposit (CD) ratio of around 90%. A CD ratio above 90% indicates higher utilization of low-cost deposits but also flags systemic risks associated with asset-liability mismatches (ALM) if not handled properly. 

HDFC Bank’s CD ratio has gone above 100% because it funded loans by issuing bonds. Post-merger, these bonds became part of HDFC Bank's books.

HDFC Bank’s credit to deposit ratio soars past 100% 

HDFC Bank’s CD ratio increased by 400 bps QoQ this quarter, reflecting its inability to raise more deposits. Conversely, Yes Bank has moderated its loan disbursement to lower its CD while also achieving higher deposit growth. 

Banks like Axis, ICICI and IndusInd are raising interest rates on term deposits to attract more depositors. They are also strategizing on opening new branches in rural and tier-2 cities to access new markets. For instance, IndusInd Bank plans to open 1,000 more branches by FY26, adding to its current network of 2,728 branches.

Banks facing liquidity crisis

Banks have been facing cash outflows due to GST and advance tax payments to the government. Additionally, the government’s decision to deposit nearly Rs 2 lakh crore with the RBI has resulted in a cash crunch for banks.

Attempts to raise funds through bond issuances have been limited by the higher interest rates provided by NBFC bonds, deterring investors. The RBI infused liquidity of Rs 1.8 lakh crore via variable repo rates from  December 16, 2023, to January 14, 2024, as a preventive measure. 

To support credit growth, banks have increased the use of their high-quality liquid assets (HQLA), resulting in a drop in liquidity coverage ratios (LCR). While most banks have an LCR above the RBI-mandated guideline of 100%, there has been a noticeable drop from the historical average of 125%.

Private banks see a decline in liquidity coverage ratio in Q3FY24

Private banks see net interest margin pressure amid loan repricing 

Private banks are also struggling with escalating cost of funds as they reprice deposits. The combination of higher lending rates and elevated CD ratios has led to the moderation of margins. Loan books are getting repriced at higher interest rates, while deposits are yet to catch up. 

Rising cost of funds squeeze private banks' NIM 

Despite analysts expecting a margin expansion, HDFC Bank’s margins remained unchanged QoQ, with a YoY drop of 90 bps. Competition from PSU banks has also constrained private banks’ ability to significantly increase their rates. 

Private banks, on average, saw only a modest 5.2 bps increase in the yield on advances (lending rates), while the cost of funds (deposits) rose by 11.2 bps QoQ. This disparity between lending rates and the cost of funds is hitting bank margins. The cost of funds is rising due to a decline in CASA and an increase in term deposits. 

Private banks see a decline in CASA ratios in Q3FY24

Although higher interest rates have attracted more deposits, the majority of these have been term deposits, which offer higher interest rates, rather than CASA. The average CASA ratio for the top five private banks dropped by 78 bps QoQ, standing at 37.5%.

Net NPAs inch up as provisions decline

In Q3FY24, a trend emerged among most private banks: gross NPAs declined while net NPAs increased. This pattern resulted from higher recoveries and writebacks. The lower provisioning in the last couple of quarters led to a marginal increase in net NPA. 

Axis Bank and ICICI Bank saw the most notable declines in Gross NPA %, with QoQ decreases of 18 and 15 bps, respectively.

HDFC Bank’s NPA shoots up post-merger

The provision coverage ratio (PCR) stands above 70% for most banks, offering a robust safety net against future NPAs. Specifically, ICICI Bank and Axis Bank have PCRs of 81% and 78%, respectively, indicating they are well-prepared to manage potential future NPAs.

Higher provisioning limits profitability

In Q3FY24, increased provisioning have affected profitability. The increase in provisioning has been on the lower side on account of increased writebacks and recoveries.

Private banks’ profitability increases on the back of lower provisioning

Banks that ramped up their provisions witnessed more modest profit increases. For example, HDFC Bank, which boosted its provisions by 39% QoQ, saw its profit growth dip to 2.7%. Conversely, IndusInd, which maintained provisions at previous quarter levels, achieved a QoQ profit growth of 4.5%.

The banking industry’s ongoing liquidity crisis will be a focal point for the next few quarters. It's important to watch how banks raise funds — whether through deposits, bond issuances, or RBI interventions — to maintain liquidity amid the rising cost of these funds. This could present a serious threat to margins. The sector has also been chasing credit growth with unsecured lending, which could be a serious problem if not monitored