Vault matters | Can banks handle a third successive rate cut?

The financial health of banks is often not the central bank's top priority when making repo rate decisions.

Macros largely favour a repo rate cut, particularly on the inflation front. However, the financial health of banks doesn't appear to align as well, based on the March FY25 results. The question then is whether banks are well-placed to absorb a third successive repo rate cut. The answer to that is mixed.

Certainly, the heightened market expectation is that another 50 basis point rate cut is more or less a given by the end of FY26. However, what remains in question is the timing of this rate cut. Credit growth remains sluggish, and the profitability of banks seems under pressure. The overall outlook provided by bank managements is far from encouraging. In such circumstances, how will a third successive rate cut play out?

If you ask bankers, they would say that the decision-making of borrowers is more influenced by their propensity to spend and supply-demand dynamics, especially in the case of corporate borrowers. It is not as much guided by the cost of credit itself.

Economists and policymakers invariably have a different view. Many believe that if the cost of funds is benign, the demand for funds will automatically increase. This may be acceptable in theory, but in practice, it is different. When the cost of funds is lower, but the financial parameters of banks—particularly profitability—are strained, banks become more selective when it comes to taking on credit risks. To put it simply, if at an interest rate of 8.5%, banks would have been willing to serve 100,000 customers in the mortgage market, at an 8% rate, the eligible pool of borrowers would naturally shrink. This is because banks may tighten their risk parameters to protect their profitability, resulting in a reduced propensity to lend.

Secondly, while most banks expected margin contraction and continue to hold that view at least until the second half of FY26, the reduction in net interest margin seen in the March quarter of FY25—ranging from 5 to 20 basis points across the sector—was something not many banks anticipated. With the competition for deposits far from abating, and deposit rates continuing to play a crucial role in attracting depositors, sharp downward repricing of deposits may not be an easy task. With at least 50% of large-ticket loans still dependent on the cost of deposits, as they are benchmarked to MCLR (marginal cost of fund-based lending rate), even if the repo rate falls by another 25 to 50 basis points in the next two quarters, banks may find it difficult to pass on this reduction to loans on a near real-time basis.

Given these circumstances, it might be more prudent for the central bank to monitor how the 50 basis point cut from February 2025 has been transmitted through the system before implementing another 50 basis point reduction. This way, the repo rate adjustments could be more calibrated, without significantly impacting the financials of banks. While the financial health of banks is often not the central bank's top priority when making repo rate decisions, considering that the banking sector is frequently seen as the window to economic growth, a more collaborative approach could prove more beneficial.