From Pressure to Pivot, Banks Shift Gears After Q4 Margin Hit

The March quarter earnings season underscored mounting pressure on margins for most lenders, unfolding against a backdrop of marginal uptick in deposit rates and softening lending rates. This squeeze comes just as the RBI embarks on its rate-cutting cycle after having reduced rates twice by 25 basis points each already, raising concerns that challenges for banks could intensify.

With further cuts anticipated, banks now face the delicate task of maintaining a balance between attracting deposits and extending credit, all while protecting their net interest margins in an easing interest-rate environment.

Rising Costs, Narrowing Spreads

According to the data from the Centre for Monitoring Indian Economy (CMIE), the aggregate net profit of 466 financial-services companies, which make up around 40% of all listed firms, rose by a mere 1.4% year-on-year in the March quarter, a steep drop from the 28% growth recorded a year earlier. The slowdown in profit growth coincided with a 113 basis point contraction in net profit margins.

A major reason behind this margin squeeze is the faster rise in expenses compared to income. Total income grew by over 8% year-on-year in Q4 FY25, but expenses climbed more quickly at 10%, according to CMIE data. Also, interest payments absorbed a larger share of earnings as interest expenses rose to 57.6% of total operating income, up from 56.1% in the same period last year, resulting in a contraction in net interest margins (NIMs) for many lenders.

Interestingly, this increase in interest expenses occurred even as the credit-deposit ratio remained stretched. RBI data highlighted by CMIE revealed that the weighted average lending rate (WALR) on fresh loans issued by scheduled commercial banks fell by 3 basis points year-on-year in the March quarter, while the weighted average domestic term deposit rate (WADTDR) edged up by 7 basis points.

Asymmetry in Loan and Deposit Repricing

With the rate cut cycle underway, lending rates are expected to fall more rapidly than in past cycles. This is largely because of the rising share of external benchmark lending rate (EBLR)-linked loans, which now make up around 61% of floating-rate credit, up from just 9% in March 2020. However, a significant portion of system-wide credit remains tied to fixed-rate and marginal cost of funds-based lending rates (MCLR)-linked loans, which are unlikely to reprice soon.

For context, EBLR-linked loans adjust faster to rate cuts than MCLR loans because they are directly tied to the RBI’s repo rate, whereas MCLR depends on a bank’s internal cost structure and changes more slowly.

On the liability side, only around 21% of term deposits are due to mature within the next year, implying a slower transmission of rate cuts to deposit rates. This mismatch in repricing speeds is expected to continue exerting pressure on NIMs, particularly as the RBI is likely to cut rates by another 50 basis points over the coming quarters.

How Banks are Shifting Strategies

To cushion the impact of rising funding costs and deposit competition, banks have increasingly turned to alternative financing sources. According to a report by SBICAPS, banks issued nearly Rs 1 lakh crore of infrastructure bonds and also tapped into the certificates of deposit (CD) market. CDs continue to offer a rate advantage, as policy rate changes are priced in more quickly in the bond markets than in traditional deposits.

Issuance of infra bonds was stronger due to high credit-deposit ratio in some banks and elevated deposit rates, which increased leverage within the banking system, investment bank SBICAPS noted. Infra bonds offer a cheaper way of raising funds as banks are not required to maintain cash reserve ratio and statutory liquidity ratio on the funds raised via this route as required for traditional deposits. Also, it serves the purpose of portfolio diversification in the current interest rate cycle.

The brokerage also pointed out that credit and deposit growth are expected to converge in FY26. In the last 50 years, credit growth has exceeded deposit growth for four consecutive fiscals only twice. Although credit growth again outpaced deposit growth in FY25, the gap has narrowed and both are expected to grow at 10-12% in the current fiscal.

As the macroeconomic environment shifts and customers explore alternatives beyond conventional bank deposits, banks will need to strike a careful balance in managing funding costs, pricing loans and maintaining profitability.