The ‘fastest growing economy’ label that India currently carries got a boost as the country’s GDP grew 8.4% YoY in the December quarter. This growth was fuelled by higher domestic consumption, with a boom in the auto and real estate sectors. However, much of this consumption has been driven by debt.
Consumers borrowing in order to buy has pushed up the growth of Indian banking sector’s loan book to 19.1% CAGR over the past two years. The Indian banking sector loan book grew by 5.6% in FY21 and 9.7% in FY22.
However current trends suggest a rising liquidity crisis among banks. Banks are facing funding shortages for lending while rising deposit costs are hurting margins. The situation is further complicated by the RBI’s decision to increase the risk weight for unsecured loans from 100% to 125%. This has restricted banks' ability to offer personal loans and credit cards. These challenges have led to the Nifty Bank index underperforming the Nifty 50 by 5.4% in the past quarter.
Despite these obstacles, banks have benefitted from decreasing non-performing assets (NPAs), lower provisioning, and writeback of recoveries, contributing to an increase in their bottom line. The Indian banking sector reported an overall YoY profit growth of 16.6% in Q3FY24, with the net interest income growth at 10.7%.
Elevated credit-to-deposit ratio limits credit growth
Lending growth has outpaced deposit growth in the banking sector. In Q3FY24, advances surged by 20.6%, while deposits grew by only 14%. The HDFC Bank merger is also partly responsible for the growth in advances.
At the beginning of FY23, banks had a credit-to-deposit (CD) ratio below 75%. The recent spike in advances has pushed the banks to rely more on deposits to fund this growth. Private banks like HDFC Bank (111%), Axis Bank (93%), Yes Bank (90%) and IndusInd Bank (89%) have reported CD ratios above 85%.
In contrast, PSU banks like SBI (75%), Punjab National Bank (75%), and Canara Bank (73%) have CD ratios below 80%. This lower CD ratio provides PSU banks more room to fund advances growth.
A higher CD ratio indicates an efficient use of the deposit base and improved net interest income (NII), but a ratio beyond 90% constrains the ability of banks to increase lending.
Higher CD ratios constrain lending growth for Indian banks
To increase their deposit base, private banks have raised interest rates on term deposits and savings accounts. These higher deposit rates have boosted deposit growth over the past two quarters. Customers are shifting funds from current accounts and savings accounts (CASA) to term deposits. Consequently, over-stretched CD ratios are expected to decline as deposits rise.
Margin pressures pose challenges amid rising costs
Banks are facing a margin squeeze due to their inability to pass on the increase in the cost of funds with higher lending rates. Banks are right now unwilling to risk reducing loan growth and increasing defaults with higher lending rates is pressuring bank margins.
The migration of funds from current and savings accounts (CASA) deposits to term deposits has increased the cost of funds for banks. This is evident in the decline in the CASA ratio across the banking sector for the past nine quarters.
Indian banking sector’s CASA ratio hits nine-quarter low
The drop in the CASA ratio is likely to continue until the RBI implements a rate cut. CASA deposits constituted 38.4% of total deposits at the end of Q3FY24, while historically banks have maintained a CASA ratio above 40%. Banks CASA ratio before FY22 averaged above 45%. This decline in the CASA ratio has resulted in a 38 bps contraction in margins over the past two quarters.
Indian banking sector’s net interest margins contract over the past four quarters
The Indian banking sector has achieved an 18.1% CAGR in NII over the past two years, driven by lower cost of funds and rising lending rates in FY23.
However, declining CASA and rising cost of funds have contracted margins in FY24, especially in the past two quarters. This is despite a 10.8% YoY growth in NII in Q3FY24. Small finance banks have led the NII growth on the back of their ability to raise lending rates while larger banks have underperformed.
Banking sector navigates through a liquidity crunch
Banks are facing a liquidity crisis after the RBI increased the risk-weighted asset for unsecured lending from 100% to 125%. This has resulted in a decline in the overall capital adequacy ratio (CAR) over the past two quarters. On average, Indian banks saw their CAR drop by 65 bps QoQ in Q3FY24.
To manage this, banks raised nearly Rs 53,070 crore through qualified institutional placements (QIP) in 2023. This momentum is expected to continue in 2024, with private banks taking the lead. However, attempts to raise funds through bond issuances have been limited by the relatively higher interest rates provided by NBFC bonds, deterring investors.
To ease liquidity pressures, the RBI infused Rs 1.8 lakh crore into the banking system using variable repo rates from December 16, 2023, to January 14, 2024.
NPAs decline due to better recovery
The Indian banking sector has seen a considerable reduction in NPAs in the past two years. From the beginning of FY21 to Q3FY24, gross NPAs declined by 40%, and the gross NPA % dropped by 467 bps to 3%.
This positive shift was led by higher recoveries and write-offs. Major private banks like CSB Bank, HDFC Bank, Karur Vysya Bank, and Axis Bank have reported gross NPA% below 1.6%. On the other hand, Bandhan Bank, Punjab National Bank, and Bank of India have Gross NPA % above 5%.
Indian banking sector’s net NPAs decline with increased provisioning
The banking sector's commitment to higher provisioning has limited net NPA growth, with nearly 95% of banks reporting net NPA% below 1.5%. This strategy has improved the banking sector's provisioning ratio. On average, banks have reported provisioning coverage ratios (PCR) above 75%, surpassing the RBI’s minimum guideline of 70%. Banks have provisioned Rs 1,19,818 crore over the past four quarters, a decline of 30% YoY.
Indian banking sector’s provisions decline consistently
While this higher provisioning impacted the sector’s profitability until the end of FY23, higher recoveries and lower provisioning have helped profitability in FY24. Provisions as a percentage of NII has fallen from a high of 31% in Q4FY22 to 13% by the end of Q3FY24.
Declining provisions and higher recoveries drive profitability
Over the past two years, profitability has surged 1.6x, even surpassing revenue growth. However, net profit growth will likely be moderate going forward, owing to slower NII growth and higher recoveries. A significant boost is expected once the RBI cuts interest rates and banks get to see the margin expansion.
Banks’ profitability increases 1.6 times over eight quarters
Recent challenges, including margin moderation and slowing loan growth, have led to a drop in Nifty Bank valuations. The P/B ratio of Nifty Bank fell from a 52-week high of 3.2 in July 2023 to 2.8 currently.
Margin pressures are expected to persist into FY25 due to rising deposit rates. The impact on NII growth may be partially offset by a higher advance base. Margin expansion can only be seen after the RBI reduces interest rates in H1FY25.
However, in the near term, dropping CARs and increasing CD ratios will add pressure to lending growth. To navigate through these challenges, banks may need to raise equity and further hike deposit rates.