Indian banks' profitability is likely to continue to improve, although net interest margin (NIM) compression will limit earnings upside over the medium term, according to Fitch Ratings.

Banks' rising funding cost is likely to remain an important factor driving NIMs, but the global rating agency Fitch Ratings expects 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).

It expects NIMs to narrow 10bp-20bp over the next two years from its current cyclical peak of 3.6% in 9MFY24. This 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. 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, Fitch Ratings said in a release on Tuesday.

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%, the release noted.

Banks would have to balance the twin objectives of growth and margins, which is evident from a slower rise in the loan-to-deposit ratios (LDRs) of Fitch-rated banks in 9MFY24. The average LDR of these banks jumped to about 79% in FY23, from 75% in FY22, as loan growth outpaced deposit growth, but the ratio rose more moderately to roughly 81% in 9MFY24. Fitch Ratings expects some gap between loan growth and deposit growth to persist, implying that banks with greater share of low-cost deposits will have the advantage.

Fitch estimates that the share of low-cost deposits fell by about 490bp to around 39% of system deposits in 9MFY24, from FY22. This was driven by greater competition and the resultant rise in the cost of term deposits, which also spurred a shift from low-cost deposits to term deposits. Most Fitch-rated banks comfortably exceed the system average in terms of low-cost deposit share, although some banks with high LDRs have had to partly rely on wholesale deposits.

Nevertheless, the rating agency believes funding would not be a significant challenge for the banks, given their reliance on local-currency deposits, and the central bank's flexible approach towards liquidity management. Moreover, it expects funding to remain stable in light of the low reliance on certificates of deposits at the system level. Customer deposits accounted for about 90% of the non-equity funding of Fitch-rated banks in 9MFY24, by our estimates.

Fitch has a positive outlook on most Indian banks' earnings and profitability (EP) score. This reflects its expectation that the improvement in profitability should drive their four-year average OP/RWAs higher, as the influence of previously weak profitability wears off. If sustainable, this could support higher EP scores in the future and potentially influence the Viability Ratings of some of these banks, provided higher EP scores are coupled with better scores on other key rating drivers, especially the risk profile.