One silver lining for the Indian economy that emerged out of the COVID-19 pandemic was the banking sector. Contrary to expectations this sector remained relatively unscathed by the pandemic, and proved to be quite resilient. In fact, FY2023 turned out to be a good year for Indian banks. Several banks declared record profits in their annual results, banking stocks rallied and there is a general sense of optimism about the banking sector. However, the way forward seems less optimistic and ridden with several challenges. To understand why, we need to look at the factors that have driven the current performance of the banking sector and analyse the reasons behind these factors not working favourably in the future.
We can attribute the recent strong performance of banks to four main factors: rising interest rates due to the Reserve Bank of India’s (RBI) monetary tightening over the last one year, asymmetric monetary transmission, post-pandemic normalisation of the economy and commensurate recovery in credit demand, especially from the micro, medium and small enterprises (MSMEs) along with the resilience of consumer credit, especially unsecured credit, through the pandemic and beyond and finally, clean-up of the bank balance sheets in the aftermath of the Asset Quality Review in 2016. It is possible that the positive impact of these factors has already been fully captured in the performance of the banking sector, and from FY2024 onwards, the situation will be quite different.
Asymmetric monetary transmission
First, between May 2022 and May 2023, the RBI steadily increased the repo rate by 2.5 percent from 4 percent to 6.5 percent in order to bring inflation down. In 2018, Indian banks had adopted external benchmark-based loan pricing as a result of which roughly 45 percent of the total loan book is now linked to an external benchmark, repo rate being the most popular one. Hence, the increases in the policy rate in FY2023 got rapidly transmitted to bank loans. Across the banking sector, the increase in loan pricing ranged from 125 to 175 basis points, depending on the composition of banks’ loan book. On the deposit side, however, the transmission was more modest, between 60 and 100 basis points. This means that banks’ net interest margins widened considerably resulting in higher profits.
Monetary transmission has always been asymmetric in India with deposits getting repriced with a lag relative to loans. This implies that going forward banks’ deposits will get continually priced up which in turn would lower margins. In this context, it is also important to note that in FY2023, total bank credit outgrew deposits by about Rs 2 trillion creating the biggest deposit-credit growth gap in the history of Indian banking. This is clearly not sustainable and will lead to either lower credit growth or higher deposit pricing, or a bit of both. Net result will be that banks’ profits will come down from the current high levels.
Second, it seems increasingly likely that we are at the end of the monetary tightening cycle. With inflation cooling off, the RBI is unlikely to raise rates any further unless there are some unexpected shocks to inflation such as deficient monsoons, etc. They may however hold the rates at the current level for a prolonged period of time given that inflation still has not hit the 4 percent target. This means that banks will not be able to push up loan pricing any further and the scope for margins to grow is therefore limited.
Slowing credit growth
Third, one factor that contributed to bank profitability in FY2023 was the remarkable uptake in credit growth. It peaked at roughly 18 percent in the first half of the year and cooled down to about 12 percent by the end of the last quarter. For the entire year, the credit growth was around 15 percent, the highest in more than a decade. This strong growth was largely driven by MSME credit growing at 16 percent and consumer credit which grew at 20 percent. On the other hand, credit to large corporations remained lacklustre and grew at merely 3 percent.
The sharp surge in MSME credit was primarily due to the credit guarantee scheme introduced by the government in the wake of the pandemic in order to support this particular sector. This implies that whether MSME credit will continue to grow in future is critically contingent upon the government extending its scheme. Moreover, in Q4 of FY2023, overall credit growth began decelerating. The trend has been especially pronounced for consumer credit as rising interest rates finally began impacting credit demand. This suggests slower credit growth in the coming quarters and hence potential reduction in bank margins.
Risk of delinquencies
Finally, right before the pandemic hit India, the banking sector was at its weakest in several decades, struggling to deal with high non-performing assets (NPAs), low capital, and declining profits. The RBI and the government initiated an elaborate clean-up of the sector. While on one hand, this aggravated risk aversion of the banks, on the other hand, it may be argued that this clean-up process helped the banking sector stay resilient despite the unprecedented shock of the pandemic and also facilitated the credit expansion when the economy started recovering from the pandemic. The bank balance sheets became better capitalised with almost all banks having excess capital which supported the credit growth. Also, by the time the pandemic came to an end in India, the cost of loan loss provisioning in the banking sector had precipitously declined. All the NPAs that haunted banks over the last decade, were completely provided for and some of the stressed loans even showed modest recovery through the resolution process initiated under the Insolvency and Bankruptcy Code (IBC, 2016). In fact, in FY2023, the banking sector witnessed the lowest cost of provisioning in more than a decade.
However, it is not obvious that this favourable environment will continue going forward. Some of the bank portfolios, such as MSMEs and unsecured consumer credit may start exhibiting higher delinquencies leading to an uptick in credit cost provisioning. If this happens then the profitability of the banking sector as a whole may decline.
In a nutshell, FY2023 saw an unusual confluence of factors all of which resulted in extraordinary performance for Indian banks, after a prolonged phase of banking sector woes. The road ahead seems bumpier with credit growth showing signs of a slowdown, and bank margins peaking and almost certain to decline. Moreover, growth in the Indian economy as a whole is expected to slow down in FY2024 owing to significant global headwinds. It will be interesting to see how the banking sector manoeuvres through this phase.
Harsh Vardhan is a Management Consultant & Researcher based in Mumbai and Rajeswari Sengupta is Associate Professor of Economics, IGIDR, Mumbai. Views are personal, and do not represent the stand of this publication.
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