RBI Rate Cuts Expected to Impact Bank Profitability, According to CRISIL

Upcoming interest rate reductions by the Reserve Bank of India (RBI) are likely to have an impact on the profitability of banks in the next fiscal year, FY26. A recent analysis by domestic rating agency CRISIL predicts a moderation in a key indicator of bank profitability: Return on Assets (RoA).

Expected Impact on Profitability

According to CRISIL Ratings, the RoA for banks is projected to decrease by 0.10 to 0.20 percentage points in FY26. This would bring the RoA down to a range of 1.1% to 1.2%, compared to the over two-decade high of 1.3% achieved in the current fiscal year, FY25. Return on Assets (RoA) is a crucial metric that indicates how effectively a bank is using its assets to generate profit.

Understanding the Drivers: Net Interest Margin

The primary factor anticipated to drive this contraction in profitability is a similar level of compression in the Net Interest Margin (NIM). NIM represents the difference between the interest income a bank earns from its loans and other interest-earning assets and the interest it pays out on deposits and other borrowings. A compression in NIM means this core profitability spread is narrowing.

CRISIL explains that in an environment where interest rates are falling, as is expected following RBI rate cuts, the interest rates on loans typically tend to reduce faster than the interest rates offered on deposits. This differential speed of adjustment directly impacts the NIM.

The Dynamics of Loan and Deposit Repricing

The agency points out that a significant portion of bank loan assets, specifically around 45%, are linked to an external benchmark, most notably the RBI’s repo rate. When the RBI cuts the repo rate, the interest rates on these linked loans are expected to be repriced downwards relatively quickly.

In contrast, any reduction in the interest rates on term deposits (fixed deposits) will only apply to new deposits or when existing deposits are renewed. This results in a slower transmission of the overall reduction in interest rates to the bank’s cost of funds (the liability side). This mismatch in the speed of repricing between assets (loans) and liabilities (deposits) leads to the anticipated compression in NIM.

Other Factors and the Challenge of Deposit Costs

While NIM compression is seen as the main driver, other factors also influence bank profitability. Credit costs, which represent the provisions banks make for potential loan losses, have seen a secular decline over several years and are now considered to have largely “bottomed out.” This means banks may not be able to rely on further significant reductions in credit costs to offset pressure on profitability.

Additionally, projections suggest that other income sources for banks and their operating expenses are likely to remain relatively flat. Therefore, the expected compression in NIM is expected to translate quite directly into a moderation of RoA, after accounting for the impact of taxes.

The extent to which NIMs will shrink ultimately depends on how effectively banks can manage their deposit costs. However, given the competitive landscape for attracting deposits observed recently, the ability of banks to significantly lower the rates they offer on deposits may be limited.

Supporting Factors

Despite the expected pressure on NIMs, some factors may provide a degree of support to lenders. CRISIL notes the Reserve Bank of India’s commitment to maintaining adequate systemic liquidity in the banking system. Recent actions by the RBI, such as a shift towards a surplus liquidity position and adjustments to the liquidity coverage ratio (which improved the metric by 6 percentage points), are seen as helpful measures for banks.

The agency also provided specific insights into the potential impact of deposit rate changes. A hypothetical 0.25 percentage point reduction in savings account rates across all banks could lead to a 0.06 percentage point expansion in NIMs. Similarly, a 0.25 percentage point cut in term deposit rates by all banks could yield a 0.04 percentage point benefit to NIMs.

Overall, CRISIL forecasts that bank NIMs will experience a compression of 0.10 to 0.20 percentage points, settling in the range of 2.8% to 2.9% in FY26. The agency recalled that NIMs had also compressed by 0.10 percentage points in FY25, but banks were able to manage this impact primarily due to the benefit of declining credit costs in that period – a factor that may not provide the same cushion in FY26.

Source – Fieo