KOCHI: If the Reserve Bank of India’s Monetary Policy Committee (MPC) decides in favour of a rate cut during its February 5-7 meeting, banks may find themselves in an unsavoury situation.
The RBI has kept the repo rate unchanged at 6.5 per cent for 24 consecutive months, marking the longest streak of an unchanged rate in the central bank’s history.
While borrowers, particularly in the home loan segment, may benefit from reduced lending rates, banks face the daunting challenge of sustaining profitability amidst already-thin margins and intense competition in the retail loan space.
Home loans: A double-edged sword
A big chunk of the retain loans are linked to repo rate as the external benchmark. Home loans, a key growth driver for banks, are closely linked to the repo rate.
A rate cut would force banks to lower their lending rates almost immediately, further intensifying competition in a market where rates are already as low as 8.5 per cent, offered by players like South Indian Bank (SIB), Bank of Baroda (BoB), and Central Bank of India.
The margins on these loans are already wafer-thin. Despite this, there exists an ongoing competition in the home loan market, as this is a secured loan and hence attracts lesser capital charge compared with other retail loans.
According to a senior official from a private sector bank, “The average cost of funds for most banks is above 7 per cent, so offering home loans at 8.5 per cent barely leaves any room for profitability.”
He said these loans are more about acquiring customers and cross-selling products than making direct profits from home loans per se.
A rate cut would worsen the situation, pushing down yields on the retail loan portfolio while leaving little room to reduce funding costs as banks are not favourably placed to build deposit base at lower rates.
Talking to analysts while discussing the Q3 performance, the MD and CEO of South Indian Bank (SIB), PR Seshadri, said if the repo rate goes down, the bank’s yield also will go down.
“We will try to contain the effect to the level we can manage. We have a substantial book that is repo linked. There will be an impact on net interest margin (NIM) if the repo is to drop ‘tomorrow’, he explained further.
Deposit dilemma
Banks are already struggling to match their deposit growth with loan growth. While a rate cut would make loans cheaper and potentially boost credit demand, unfortunately for banks it throws up newer challenges.
With a deposit-starved banking system, the banks do not enjoy the luxury of having much flexibility with deposits. Reducing deposit rates to align with lower lending rates is not always feasible, as banks need to ensure liquidity and retain depositors.
This mismatch leaves banks in a tough spot – compelled to hunt for deposits at competitive rates even as lending yields shrink, further exacerbating their balance sheet metrics.
NIMs under pressure
The Net Interest Margin (NIM), a critical profitability indicator, is already under strain for many banks. A rate cut would squeeze margins further, as banks would have to lower lending rates immediately but might not be able to adjust deposit rates at the same pace due to the asset-liability management compulsions as discussed before.
This imbalance could make it even harder for banks to sustain their already delicate financial metrics.
A balancing act for banks
While a repo rate cut might be intended to stimulate credit growth and support the economy, it could backfire for banks. With fierce competition in the lending space and mounting pressure to mobilise deposits, banks could face a scenario where profitability takes a significant hit.
For now, while borrowers stand to gain from a rate cut, banks are wary of the consequences. The decision could push them into a cycle of lower margins, higher funding costs, and intense competition – making the road ahead all the more challenging.
