Banks' NIM may shrink by 10-20 bps in next 2 years over higher funding costs: Fitch Ratings

There could be a shrink in the net interest margins (NIM) of Indian banks over the next two years from its cyclical peak of 3.6 per cent in the first nine months of FY24, Fitch Ratings said in a report.

The shrink in the margin will be caused by higher funding costs triggered by heightened race for deposits, normalising liquidity conditions, and elevated loan growth, the rating agency said.

"We expect NIMs to narrow 10bp-20bp over the next two years from its current cyclical peak of 3.6% in 9MFY24. Our expectation is driven by rising funding costs due to greater competition for deposits, fuelled by normalising liquidity conditions and elevated loan growth. Fitch believes there is room for banks to lower operating and credit costs to offset the impact, driven by cost control and increasing efficiency from digitalisation, and scope for impaired-loan ratios to fall further across most banks," the ratings agency said.

Fitch Ratings added that there is room for banks to lower their operating and credit costs to offset the impact, driven by cost control and increasing efficiency from digitalisation, and scope for impaired-loan ratios to fall further across most banks.

"Banks' rising funding cost is likely to remain an important factor driving NIMs, but we expect earnings to be resilient despite the sector's dependence on net interest income, which contributed 75% of total operating income in the nine months of the financial year ending March 2024 (9MFY24)," said Fitch Ratings.

"However, additional improvement in their operating profit /risk-weighted assets (OP/RWAs) could be limited if banks continue to fund higher risk-weighted loans, such as consumer credit and loans to non-bank financial institutions, aggressively," it added. 

Indian banks are likely to further reallocate their investments in government securities in excess of statutory reserve requirements towards loan growth. This will continue to offset pressure on margins in the near term, but banks' higher risk appetite would also drive up the risk density. 

"The ongoing shift from investments to loans is reflected in the rising proportion of loans in the banking sector's assets to about 63% in 9MFY24 from 56% in FY22. This is also evident from the average liquidity-coverage ratio of Fitch-rated banks normalising to 127% from 139%. Nevertheless, there is additional headroom, as the ratio is well above the minimum requirement of 100%," it added. 

The ratings agency said it is bullish on the profitability front of the banks and said that profits will improve, though NIM compression will limit the earnings upside over the medium term.