The Reserve Bank of India's (RBI) recent rate cuts are expected to cause a slight contraction in the profitability of banks in FY26, according to a report by Crisil Ratings. The Return on Assets (RoA), a critical profitability metric, is forecasted to decline by 0.10-0.20 percentage points to 1.1-1.2% from a two-decade high of 1.3% in FY25. This reduction is largely attributed to a compression in Net Interest Margins (NIMs) as loan rates decrease faster than deposit rates. While credit costs have stabilized, the ability of banks to manage deposit rates will be key to mitigating further profitability pressures.
Projected Decline in Return on Assets Amid Rate Cuts
The Indian banking sector is poised to face profitability challenges in FY26 due to the Reserve Bank of India’s (RBI) recent series of rate cuts. A report by Crisil Ratings forecasts that the Return on Assets (RoA), a key indicator of profitability, will experience a decline of up to 0.20 percentage points, dropping from the record high of 1.3% in FY25 to a range of 1.1-1.2% in FY26.
The contraction in RoA is primarily driven by a compression in Net Interest Margins (NIMs), which directly affects the profitability of banks. With interest rates on loans anticipated to decrease more rapidly than those on deposits, banks will face challenges in maintaining their profit margins. In an environment where rates are falling, the dynamics of loan and deposit rate adjustments are critical in determining the financial performance of lenders.
Key Drivers of Profitability Contraction
The central cause behind the projected dip in RoA is a tightening of Net Interest Margins. As per Crisil Ratings, around 45% of loan assets in the banking sector are linked to external benchmarks like the repo rate, which tend to reprice quickly following rate cuts. On the flip side, reductions in term deposit (TD) rates are applied only to new deposits and renewals, causing a slower transmission of lower rates on the liability side of banks' balance sheets. This disparity between the speed of loan rate reductions and deposit rate adjustments creates a compression in margins.
Crisil's Director, Subha Sri Narayanan, highlighted this issue, noting that the reduction in loan rates typically happens faster than that in deposit rates, leading to a potential squeeze in banks’ profitability. The slower pass-through of rate cuts on the liability side makes it harder for banks to offset the falling yields on their assets, thereby impacting overall profitability.
Impact of Credit Costs and Operating Expenses
While the compression in NIMs remains the most significant driver of declining profitability, other factors such as credit costs and operating expenses also play a role. Crisil noted that credit costs have already reached a bottom after years of decline, meaning there is limited room for further reduction. With operating expenses and other income expected to remain largely flat, the reduction in NIMs is likely to directly result in a moderation of the RoA after accounting for tax impacts.
Banks’ ability to manage credit costs has been a positive factor in offsetting the impact of compressed margins in recent years, but this trend may not be sustainable moving forward. As credit costs have stabilized, banks will have to focus on other areas of efficiency to maintain profitability.
Managing Deposit Rates in a Competitive Market
An additional challenge for Indian banks is the intense competition for deposits, which has escalated in recent times. Given the higher competition, banks may find it difficult to keep their deposit costs under control, further aggravating the impact of compressed NIMs. The ability to manage deposit rates effectively will be crucial for banks to navigate the challenging environment created by the RBI's rate cuts.
Despite these challenges, the RBI’s focus on maintaining systemic liquidity and its shift to a surplus position could offer some relief to banks. The recent adjustments to the Liquidity Coverage Ratio (LCR), which improved the metric by 6 percentage points, are expected to provide a buffer for lenders, supporting overall stability in the banking system.
Small Gains from Deposit Rate Cuts
Despite the overall pressure on NIMs, there are some opportunities for banks to boost their margins by adjusting deposit rates. According to Crisil, a 0.25% reduction in savings account rates could lead to a 0.06% expansion in NIMs. Similarly, a similar cut in term deposit rates may yield a 0.04% benefit. However, these gains are not expected to fully offset the pressures caused by the broader decline in interest rates.
Conclusion: A Mixed Outlook for Banks in FY26
The outlook for India’s banking sector in FY26 is a mixed one. While rate cuts by the RBI provide benefits to borrowers and the broader economy, they come with an impact on bank profitability. The contraction in NIMs, driven by the faster reduction in loan rates compared to deposits, is expected to weigh on banks' Return on Assets. Credit costs have stabilized, but deposit competition will make it difficult for banks to manage their cost of funds effectively.
Banks will need to adapt by managing their deposit strategies, focusing on operational efficiency, and leveraging liquidity support measures from the RBI. The ability of individual banks to navigate this challenging environment will determine how well they can maintain profitability and growth.
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