Indian banks are likely to resist mounting government pressure to sharply cut rates as they grapple with expensive deposits raised at the height of the credit crisis and rising bond yields.
Government wants banks to lend more and cheaply to boost economic growth, following other Asian economies such as China, which lifted limits on bank lending to grease the wheels of its economy.
The pressure is adding to the risks for shares of state-run banks, which have underperformed the bank index and privately held banks this year.
"Profitability and margins could be under pressure particularly if specific Indian banks pursue a very aggressive growth strategy and decrease the spread earned on banking products," said Brayan Lai, a credit analyst at Calyon in Hong Kong.
"From a top down perspective, I prefer Indian state-run banks due to their quasi-sovereign backing and recapitalisation plans but, from a bottom-up approach, I'd be worried as some dubious lending may take place," he said.
Shares of the country's biggest lender State Bank of India have gained 32 per cent so far this year, lagging a 46 per cent gain in the bank index and a 57 per cent jump in shares of privately held ICICI Bank.
SBI and its associates control a quarter of all loans, and state-run banks as a sector corner 55 per cent of all assets.
SBI cut its deposit rate by 25 basis points, its fourth cut in 2009, but has yet to reduce its lending rate. Chairman O.P. Bhatt said the economic recovery was yet to reflect on banks' asset growth and passing on rate cuts to customers will take time.
With bank loan growth slowing sharply, policymakers worry that by not passing on to customers the deep cuts in official rates these banks may threaten an economic revival.
While the central bank has cut its main lending rate by 425 basis points since October, state-run banks have cut their lending rates by 150-200 bps.
Loan growth has slowed from around 27 per cent in November to around 15 per cent in early June and halved from rates of around 30 per cent seen in the financial year to March 2008.
At a meeting with the heads of state-run banks last week, Finance Minister Pranab Mukherjee urged them to follow the central bank and reduce interest rates.
Bankers say more deposit rate cuts would lead to a flight of money from bank deposits to federal schemes that yield an attractive 8 per cent tax-free rate.
"Banks are at a crossroads: if they keep cutting their deposit rates, they won't get the funds and if they don't get the resources what will they lend," said K. Ramakrishnan, chief executive of the Indian Banks Association, an industry body.
CARE research data showed these schemes have lost heavily to bank deposits which accounted for 55 per cent of household schemes at March 2008. In 2004, these schemes garnered 20 per cent of savings and their pool shrank by nearly 4 per cent last year.
"To me, current interest rates are fair and are conducive enough for healthy loan growth when the economy turns," Ashish Parthasarthy, deputy treasurer at HDFC Bank, said.
Private sector lenders such as HDFC Bank and ICICI, while free from government pressure to cut rates, will still need to follow state-run banks or lose customers.
Angel Broking analyst Vaibhav Agrawal estimates a 10-20 bps drop in margins in the next two quarters after a 40 bps fall in the March quarter.
Privately held banks such as ICICI, Yes Bank, Kotak Mahindra Bank and mid- to smaller state-run banks such as Dena Bank, Corporation Bank and Oriental Bank of Commerce will gain as they rely more on bulk deposits, he said.
Goldman Sachs said banks' return on equity will fall to 14.3 per cent in 2009 from 16.6 per cent a year ago as net interest margin shrinks to 3.45 per cent from 3.65 per cent in 2008, with state-run banks being affected the most.
Another factor worrying banks are rising bond yields.
Banks have to park roughly a quarter of their deposits in bonds, and benchmark yields are up 156 bps this year, squeezing their margins.
"You can't have a situation where banks' deposit rates are falling and benchmark yields are going up," said J. M Garg, chairman of state-run Corporation Bank.