Net interest margin of banks are likely to shrink over the next two years from its cyclical peak of 3.6 per cent in the first nine months of 2023-24, Fitch Ratings said in a report on Tuesday.

This will be caused by higher funding costs triggered by a heightened race for deposits, normalising liquidity conditions and elevated loan growth, the rating agency said.

“We expect NIMs to narrow 10bp-20bp over the next two years from its current cyclical peak of 3.6 per cent in the first nine months of 2023-24.

“Fitch believes there is room for banks to lower operating and credit costs to offset the impact, driven by cost control and increasing efficiency from digitalisation, and scope for impaired-loan ratios to fall further across most banks,” the rating agency said.

Rising funding costs are likely to remain an important factor driving NIMs. But earnings will remain resilient despite the sector’s dependence on net interest income, which contributed 75 per cent to total operating income in the nine months of 2023-24.

Additional improvement in operating profit/risk-weighted assets (OP/RWAs) could be limited if banks continue to fund higher risk-weighted loans, such as consumer credit and loans to non-bank financial institutions.

Banks are likely to further reallocate their investments in government securities above statutory reserve requirements towards loan growth. This will continue to offset pressure on margins in the near term, but banks’ higher risk appetite would also drive up the risk density.

“The ongoing shift from investments to loans is reflected in the rising proportion of loans in the banking sector’s assets to about 63 per cent in the first nine months of this fiscal from 56 per cent in 2021-22. This is also evident from the average liquidity-coverage ratio of Fitch-rated banks normalising to 127 per cent from 139 per cent. Nevertheless, there is additional headroom as the ratio is well above the minimum requirement of 100 per cent,” Fitch said.

The ratings agency said it is bullish on the profitability front of the banks and said that profits will improve, though NIM compression will limit the earnings upside over the medium term.

Fitch estimated the share of low-cost deposits fell about 490 basis points to around 39 per cent of the system deposits in the nine months from 2021-22. This was driven by greater competition and the resultant rise in the cost of term deposits, which also led to a shift from low-cost deposits to term deposits.

“We believe funding would not be a significant challenge for the banks, given their reliance on local-currency deposits, and the RBI’s flexible approach towards liquidity management,’’ Fitch noted while pointing out that it has a positive outlook on most Indian banks’ earnings and profitability score.

With inputs from Our Mumbai Bureau