Vault Matters: Are banks steady to absorb a rate cut?

It seems a rate cut in India is unlikely till inflation is put in the corner.

This is a huge narrative building around us, making a strong case for why the Reserve Bank of India should consider trimming the benchmark repo rate at the earliest. In fact, two of the outgoing members of the monetary policy committee have for long been in favour of a rate cut.

However, as where things stand, it seems a rate cut in India is unlikely till inflation is put in the corner where it ought to belong –well within the 2 – 4 percent comfort zone. This is a narrative that India has set for itself and the monetary policy committee has stood by its stand that inflation sustainably staying at this range is important.

While a section of India Inc is of the view that elevated interest rates may force businesses to hold back from tapping the bank borrowing channels, and eventually slow down growth, the fact is that banks themselves may not be comfortably positioned to handle a rate cut at this point.

Firstly, a very peculiar thing is presently playing out across most banks.

There was fast transmission of repo hikes on the lending side. But transmission of on deposits was a bit slow till mid-2023. Today, particularly for mid-size to smaller banks, transmission on deposit rates may have outpaced that of transmission on lending rates. If indeed there is a war for deposits going on, then the chances that deposit rates may be adjusted downwards to accommodate a repo rate cut doesn’t seem like a possibility in the near term. On the other hand, the assets side of a bank’s balance sheet will see an immediate transmission of a reduction in repo rate. What this would mean is that at one end banks will have to spend more money to secure their deposits, while on assets, they may have to forgo some part of their income.

Such a proposition can have an adverse impact on profitability of banks.

To extend this argument a little, net interest margin, which is a measure of profitability of banks, had already softened significantly in FY24. NIMs for the first quarter of FY25 was faced with equal headwinds. From FY22 to now, that is, when repo rate was the lowest at 4 percent to now at 6.5 percent, NIMs have reduced 70 – 120 basis points across banks.

Unless banks get to a position on their liabilities front where they can comfortably take the pedal off from tinkering on deposit rates, it would be difficult for them to absorb a rate cut just yet. In fact, a rate cut could do more harm than good for banks at this point.

Therefore, while the overall narrative is being built around reduction of interest rates globally, the dynamics in India is very different from what is playing out in the US or elsewhere.

The US for one isn’t a deposit dependent market for banks. Banks often source their liability requirements from institutional entities and hence a reduction in benchmark rate will be advantageous to them. Also, a normalisation of interest rates may help the economy nudge inflation comfortably near the 2 percent mark, guided by the Fed.

That’s not quite the case in India. If demand for large corporate loans is still in the pick-up mode, reducing interest rates by 30 or 50 basis points isn’t going to move the needle much in terms of jacking up the corporate loan demand. India has demonstrated several times that if the US sneezes, we don’t even pull out the kerchief to protect our nose. The days of catching a cold is quite behind us. Then why trail US on rate cuts?