Indian banks are expected to face a challenging period ahead as their return on assets (RoA) is projected to decline over the next 24-30 months. An analysis conducted by McKinsey & Co on Wednesday estimated the RoA range to be between 0.8% and 1%. The primary reason for this expected decline is the contraction of net interest margins (NIMs) caused by the repricing of deposits.
In recent years, the RoA of the banking system has been on an upward trajectory, improving from -0.2% in FY18 and 0.9% in FY22 to 1.1% in FY23. However, Peeyush Dalmia, senior partner at McKinsey, cautioned that a 12-18 month view suggests a likely fall in RoAs. The quarterly results and projections of various banks also point towards pressure on NIMs in the coming period.
Dalmia emphasized that the drop in NIMs will significantly impact RoA, making it difficult for other factors to compensate for the decline. Although the RoAs dipped to -0.2% in FY13, they have since rebounded to reach 1.1%, reaching a 10-year high in banking profitability.
One of the factors contributing to the current high NIMs is the faster growth of retail loans, which have become a substantial share of total banking advances. In contrast, corporate loans have witnessed slower growth rates. Dalmia highlighted that retail loans provide banks with the maximum amount of NIM.
Another crucial factor affecting NIMs is the cost of deposits. Despite the rise in rates, lenders have managed to pass on the new rate to borrowers. This is primarily because a significant proportion of lending, around 70-75% today, is based on floating rates, allowing for a quicker transmission of rate changes to borrowers than to deposits.
Looking forward, McKinsey predicts that the compression of NIMs will persist as the lag in deposit costs catches up. Historically, 30-40% of loans were floating rate, whereas currently, a much larger portion is based on floating rates, which contributes to the NIM compression.
Despite the impending challenges, Indian banks have remained strong and outperformed their global peers in terms of growth and profitability over the past five years, even amidst recent global banking turmoil. The retail and micro, small, and medium enterprises (MSME) lending segments have been instrumental in driving profitability for a significant portion of the banking system. Additionally, the consolidation of public sector banks (PSBs) has resulted in larger and healthier institutions.
As the banking sector navigates the evolving landscape, it remains to be seen how banks will adapt to the changing environment and maintain profitability amidst declining Return on assets and NIMs.