Banks winning in a high interest rate environment

December 14, 2022   |   Pulkit Saini

The RBI has been on a spree of increasing the repo rates to curb inflation. The repo rates as of now stands at 6.25% which was 4% in March 2020.

The bank’s major source of income is the difference in interest rate it earns from lending money and receiving the money. Thus, ideally, the bank aims at acquiring the funds at a lower interest rate and lending out that money at a higher interest rate, and the differential is what the bank earns. This differential in banking terminology is called Net Interest Income, the higher the net interest income the better it is for the bank’s profitability. Thus, two things that affect the movement of this net interest income are the rates at which the banks receive money (aka the deposit rates) and the rate at which it lends money (aka loan rates).

A large part of a bank’s lending rate is tied to an internal benchmark (MCLR or BPLR) or to an external benchmark (like repo). Close to 30-40% of bank’s loans are repo-linked and those banks with a heavy mortgage loan portfolio like ICICI Bank and Axis Bank have +40% of their loans linked to repo rates. Now that the RBI has been hiking repo rates, the bank’s loan portfolio which is linked to the external benchmark would also rise. Resulting in the banks getting a higher rate of interest on the loans they give out and thus resulting in better yields and an expansion in their net interest income.

It has been observed that the cost of funds (aka the deposit rates) is slow to increase in comparison with the lending rates and this is on three accounts. First, the customer maintains some balances in their current and savings account (CASA), these accounts carry a low-interest rate and are not frequently changed. Thus, the banks with a higher CASA ratio like Kotak Bank and ICICI bank stand to benefit. Secondly, customers also maintain a fixed deposit with banks, where the rates are locked until they mature, and thirdly, there are fewer incentives for the banks to raise their deposit rates and cut their profit margins, especially in the current scenario where liquidity is abundant. Thus, the rise in lending rates but a lag in the increase in deposit rates assist banks to increase their Net Interest Income.

Meet the author

Pulkit Saini
Associate – Equity Research

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