RBI rate hike could lift large banks' margins by 10 bps
A potential 25-bps repo rate hike by the RBI could expand net interest margins for large banks by up to 10 bps and lift EPS estimates by 5 per cent.
A potential 25-basis-point repo rate hike by the Reserve Bank of India (RBI) is poised to provide a significant boost to the profitability of major banking institutions. According to a recent report by IIFL Capital, such a move could expand the net interest margins (NIMs) of large banks by as much as 10 basis points and drive earnings per share (EPS) estimates upward by up to 5 per cent.
The Monetary Policy Committee (MPC) has already signaled a shift in direction, unanimously raising the repo rate by 25 basis points to 5.5 per cent and transitioning its policy stance from 'neutral' to 'calibrated tightening.' This strategic shift sets the stage for a ripple effect across the financial sector.
Impact on Margins and Earnings
The brokerage's sensitivity analysis provides a detailed breakdown of how these interest rate changes might influence different types of lenders. For the larger banking entities, the report suggests:
- Net Interest Margin (NIM) Expansion: Expected to range between 6 and 10 basis points.
- Earnings Per Share (EPS) Growth: Estimates could see an upgrade of 3% to 5%.
Interestingly, the report notes a divergence in how Public Sector Undertaking (PSU) banks might react. While PSU banks are expected to see lower NIM expansion compared to their private counterparts, the pass-through effect to their EPS is likely to be higher.
Accelerated Growth Projections
Looking toward the long term, the outlook for India's banking sector remains robust. If the RBI implements a cumulative rate hike of 50 basis points, the sector could witness a significant acceleration in growth. The report suggests that the compound annual growth rate (CAGR) for earnings per share could jump to 20 per cent over the FY26–FY28 period, a substantial increase from the current estimate of 14 per cent.
The speed at which banks benefit from these hikes will largely depend on their loan structures. Banks with a higher proportion of repo-linked loans are expected to experience much faster loan repricing compared to lenders dealing primarily with fixed-rate products.
Liquidity Tightening and Market Dynamics
While the outlook for earnings is positive, the banking system is facing a tightening liquidity environment. Liquidity has seen a sharp decline, dropping from a recent peak of Rs 11 trillion to approximately Rs 5 trillion, which represents about 2 per cent of net demand and time liabilities (NDTL).
Several factors are contributing to this squeeze, including:
- Increased currency circulation.
- Regulatory measures such as US dollar sell-buy swaps.
- Variable rate reverse repo (VRRR) operations.
- Open market operation (OMO) sales and foreign exchange interventions.
As liquidity tightens, the report anticipates a gradual rise in the weighted average call rate (WACR) and three-month certificate of deposit (CD) rates.
The Risk-Reward Proposition
The report also highlights a notable trend in banking sector valuations throughout this calendar year. While mid-sized banks have seen their valuations climb by 5–25 percentage points, public sector banks have faced a decline in the same range. Large private sector banks, however, have remained relatively unchanged.
Given this volatility, IIFL Capital suggests that large private sector banks currently offer a more attractive risk-reward proposition for investors compared to the re-rated mid-size banks or the de-rating PSU banks.