West Asia tensions unlikely to directly hit banks, but higher energy costs pose risks: Moody’s

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• Tensions may raise energy costs, impact bank asset quality
• Banking sector outlook remains stable with benign asset quality
• Deposit and credit growth balance each other over economic cycles

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Geopolitical tensions in West Asia may not have a direct impact on the overall banking sector, although there is a likelihood that higher energy prices could raise operating costs for firms, and thereby, financial buffers could take a hit, Amit Pandey, Vice President, Financial Institutions Group, Moody's Ratings, said.

Pandey said that this could increase the risk of loan repayment stress and potentially weigh on banks’ asset quality.

Speaking at a public event on March 10, officials at the credit ratings agency said that the outlook for the overall banking sector looked stable, with asset quality remaining benign and credit growth expected to be low-mid teens for the fiscal year 2026-2027.

Edited excerpts:

Given the geopolitical turmoil in West Asia, how is the banking sector poised to weather this?

It's not just the banking sector; it's an overall economic problem. Higher energy prices raise expenses for businesses and individuals, reducing the financial buffer they have after meeting daily costs.

As soon as that buffer shrinks, both at the firm or an individual level, then the chances of not repaying your loan increase, which could have implications on the asset quality of banks. Assuming that the stresses remain for a long period of time, the chances are that the financial market volatility would also be high.

Moreover, higher oil prices raise India’s import bill, which can widen the current account deficit and put pressure on the Indian rupee. This combination of higher costs, weaker currency, and higher interest rates can further reduce borrowers’ financial buffers and can indirectly affect banks.

What is your view on what the RBI is likely to do in the coming MPC? 

I think it's too early to do anything about the interest rate based on this conflict. Because we have to see whether these tensions are a few-week kind of affair or a long-term thing.

Deposit growth has been lagging behind credit growth in the last few quarters. Is this divergence now a structural issue for the banking system? 

The gap between deposit growth and credit growth is generally cyclical rather than structural. Deposit growth in India tends to remain relatively stable over time, while loan growth fluctuates depending on economic cycles. So when loan growth is lower, the loan-to-deposit (LD) ratio reduces, and vice versa.

Loans cannot continue to grow faster than deposits forever because of regulatory requirements such as the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR), which force banks to set aside a portion of deposits rather than lend them. The thing is, deposit and credit growth balance each other out.

So if you go back to COVID times, loan growth fell, and deposit growth actually improved a little bit as people started saving. So then the LD ratio fell. Then, when the economy opened up, loans started picking up again, and the ratio rose again.

Do you think banks have been able to pass on the RBI rate cuts well to their customers? What is your view on bank margins for the near-term? 

The rate cuts have gone through for the customer.  I do notice that deposit rates fell, and the loan rate also fell after the cut.

A large chunk of loans is linked to the floating rate. So if the RBI changes the interest rate, and it is linked to some external benchmark, your loans get repriced very fast. On the other hand, even if I cut my deposit rate, you will not reprice that existing fixed deposit. So when the fixed deposit matures, then the new rate comes in. So, the loan rate tends to go down first and the deposit later.

So, as a result, banks may experience temporary margin compression. However, this process usually normalises within one to two quarters once deposit repricing catches up.