Private Banks See Deposit Revival but Face Margin Pressures Amid Rising Costs

The Indian banking sector is witnessing significant changes, particularly in the dynamics of deposits and credit growth. With private banks showing signs of a catch-up in deposit growth, there’s cautious optimism. However, this comes with a stark warning: interest margins are likely to compress further. While banks are striving to regain lost ground, especially in the private sector, challenges such as elevated credit-to-deposit (C/D) ratios and a shift in retail investment preferences are weighing heavily on their profitability.

The War on Deposits
Indian banks, especially private sector players, have been caught in a fierce competition to attract deposits. The deposit war has intensified as retail investors increasingly prefer capital markets over traditional banking products. This shift has created a dual challenge for banks: not only are they losing their core deposit base, but they also need to pay higher interest rates to secure incremental deposits. The result is a hit on their net interest margins (NIMs) and, consequently, their profitability.

The decline in the core deposit base is particularly concerning as it forms the backbone of a bank’s funding structure. The shift of surplus liquidity away from banks toward capital markets has forced banks to revise interest rates upward to stay competitive. This trend has led to a squeeze in margins, especially for those banks that rely heavily on term deposits. With lower-cost CASA (current and savings account) deposits stagnating or declining, many banks are finding it increasingly difficult to maintain healthy interest margins.

Deposit Catch-Up in Q2
The quarterly business updates of several banks provide insights into how they are navigating these challenges. A closer look at 11 commercial and small finance banks reveals that eight of them reported a higher growth rate in deposits compared to advances on a quarter-over-quarter basis. This trend is particularly evident among private sector banks that were previously operating with very high C/D ratios.

At the system level, deposit growth has seen a slight recovery. By the end of Q2 FY25, overall deposit growth stood at 11.5 percent year-on-year (YoY), compared to 10.6 percent at the end of Q1. On the other hand, advances registered a 13 percent YoY growth, a moderation from the 13.9 percent growth seen in the previous quarter. The gradual moderation in the C/D ratio is a positive sign, as it suggests that banks are becoming more cautious in managing their lending portfolios in the face of deposit challenges.

Despite this improvement in deposit growth, the bigger issue remains: declining CASA deposits. With the rising cost of term deposits and stiff competition in the lending market, many banks are seeing stagnation or a decline in their share of low-cost deposits, leading to margin compression.

Impact on Interest Margins and Profitability
The resurgence in deposit growth is not without its challenges. For many banks, the increased cost of term deposits has already started to weigh on their interest margins. This is a trend that is expected to continue as competition for deposits intensifies and the overall cost of funds rises.

The moderation in interest margins is compounded by a rise in operational costs. Banks are spending more on technology upgrades, branch expansions, and hiring, all of which are necessary to attract deposits in a more competitive environment. As these expenses rise, banks are also facing pressure on their return on assets (RoA). The bottoming out of credit costs has provided some relief, but it is not enough to offset the rising cost-to-income ratio that banks are grappling with.

Outliers and Opportunities
Amid these challenges, a few banks have managed to outperform. Bank of Baroda, a large public sector player, reported robust growth in advances, outpacing deposit growth, thanks to a relatively better C/D ratio. This trend positions the bank well to capture a larger share of the lending market, even as others struggle to balance the deposit and credit equation.

Federal Bank also stands out, with an improving CASA share that signals some stability in its interest margins. Despite a tepid deposit performance in Q2, the bank’s strong growth in advances and its efforts to maintain a healthy CASA ratio are encouraging signs. CSB Bank is another exception, benefiting from the buoyant gold loan market, which forms nearly 45 percent of its loan book. The bank managed to achieve strong growth in both deposits and advances, setting it apart from its peers.

Outlook
Looking ahead, the gradual weakening of bank RoAs seems inevitable as interest margins compress, costs rise, and credit costs stabilize. However, there remains value in many frontline private sector banks. The upcoming earnings season will be closely watched to see how banks navigate this challenging environment and whether they can continue to offer value to investors despite these headwinds.

In conclusion, while private sector banks are seeing some revival in deposits, they face significant challenges in maintaining profitability. With rising costs, stagnant CASA growth, and increasing competition, the road ahead may be tough, but there are still opportunities for well-managed banks to thrive.

The image added is for representation purposes only