Indian banks' profitability to remain resilient despite margin pressure: Fitch

New Delhi, Mar 26: The profitability of Indian banks 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 costs is likely to remain an important factor driving NIMs, but it is expected that earnings will be resilient despite the sector's dependence on net interest income, which contributed 75 per cent of total operating income in the first nine months of the financial year ending March 2024.

Fitch expects NIMs to narrow by 10-20 basis points over the next two years from their current cyclical peak of 3.6 per cent.

"Our expectation is driven by rising funding costs due to greater competition for deposits, fuelled by normalising liquidity conditions and elevated loan growth," Fitch said.

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.

Indian banks are likely to further reallocate their investments in government securities in excess of statutory reserve requirements towards loan growth, it asserted.

"This will continue to offset pressure on margins in the near term, but banks' higher risk appetite would also drive up the risk density," it noted.

The ongoing shift from investments to loans is reflected in the rising proportion of loans in the banking sector's assets, which rose to about 63 per cent in 9MFY24 from 56 per cent in FY22.

Further, it noted that 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.

"We expect 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 added.

Fitch estimates that the share of low-cost deposits fell by about 490 basis points to around 39 per cent of system deposits in 9MFY24, from FY22.

On funding, Fitch said it would not be a significant challenge for the banks, given their reliance on local currency deposits, and the central bank's flexible approach to liquidity management. Fitch has a positive outlook on most Indian banks' earnings and profitability score.

Separately, the health of the Indian banking sector continues to improve with better asset quality and high credit growth, a survey conducted by industry body FICCI and banking association Indian Banks' Association (IBA) showed recently. Those banks that were surveyed together represent about 77 per cent of the banking industry, as classified by asset size.