Girja Shankar Kaura
Rising interest rates will boost banks’ margins but the increase will be limited. Asset risks for banks will also increase but the deterioration will not be significant because of improved underwriting standards and prior recognition of legacy problem loans, Moody’s Investors Services has said.
In its latest reports Moody’s said, inflation in India is accelerating, leading the Reserve Bank of India (RBI) to hike its policy rate, with more rate hikes on the cards. RBI has raised its policy rate by a total of 190 basis points in 2022, in response to accelerating inflation.
Rising interest rates will slow economic growth. However, the operating environment for banks will not deteriorate significantly and India’s economy will continue be one of the fastest growing large economies in the world. While rising interest rates will result in increases in banks’ net interest margins (NIMs), improvements in their overall profitability will not be significant. Firstly, gains in NIMs will be limited and not proportional to increases in interest rates because funding costs will rise faster than loan rates. Also, banks will incur valuation losses on their holdings of government securities as yields rise.
The performance of corporate and retail loans will be largely stable because of improved underwriting and prior recognition of legacy problem loans. Loans to small and medium-sized enterprises (SMEs) will see deterioration in asset quality because this segment is the most vulnerable to interest rate rises. With real rates remaining low on an absolute basis, the central bank may further hike rates. At the same time, the current pace of inflation in India and interest rates are not high relative to historical levels.
Even if the RBI tightens monetary policy further, interest rates will not rise to the high levels seen in the past. Inflation and the pace of rate hikes in India remain low relative to global peers. Rising interest rates will slow economic growth, resulting in downside risk to asset quality for banks. However, the operating environment for banks will not deteriorate significantly and India’s economy will continue be one of the fastest growing large economies in the world. The strong credit growth is a reflection of this growth outlook.
While rising interest rates will result in increases in banks’ NIMs, improvements in their overall profitability will not be significant. Firstly, gains in NIMs will be limited and not proportional to increases in interest rates because funding costs will rise faster than loan rates. Also, banks will incur valuation losses on their holdings of government securities as their yields rise.
NIMs will widen, but modestly NIMs will increase but only around 15-25 basis points, lagging rises in interest rates. Sizable proportions of Indian banks’ deposits are from current and savings accounts (CASAs), which are less sensitive to changes in interest rates than term deposits. At the same time, increasing shares of banks’ loans have floating rates linked to repo rates or other benchmarks, which accelerates increases in their overall loan rates when interest rates rise. As such, rises in interest rates in India will lead NIMs to widen.
Indian banks’ asset quality will be resilient to relatively moderate increases in interest rates. The performance of corporate and retail loans, which account for the bulk of Indian banks’ loan portfolios, will be largely stable owing to banks’ prior efforts to improve underwriting and recognize legacy problem loans. The asset quality of loans to SMEs will increase as this segment is the most vulnerable to interest rate increases.
The quality of corporate loans has improved following an RBI review of banks’ asset quality in 2015, which resulted in banks have classifying most weak exposures as NPLs and resolved them or writing them off. Banks have also strengthened underwriting for the corporate segment in the past few years, focusing on corporates with strong credit worthiness, it said.
