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Stung by Surging Cost of Funds, Banks may Flag Tight Liquidity

Analysis of Banks Facing Liquidity Crunch
Source: Original reporting by ET Bureau on January 20th, 2024, published in Economic Times.

Analysis for a Layman 

Banks are currently grappling with a liquidity shortage due to the Reserve Bank of India’s (RBI) sustained efforts to reduce money supply in the financial system, aiming to control inflation. This tightening of liquidity has led to increased borrowing costs for banks, impacting their profit margins.

Stung by Surging Cost of Funds, Banks may Flag Tight Liquidity

Impact on Retail Investors 

For retail investors in bank stocks, the situation indicates potential pressure on the sector’s profitability. The rising cost of funds for banks, without a corresponding increase in lending rates, squeezes profit margins. Investors should assess banks based on their deposit profile and the duration mismatches in their assets and liabilities.

State-owned banks with a higher proportion of low-cost CASA (Current Account Savings Account) deposits are better positioned than private banks relying more on wholesale funds. Monitoring the trajectory of margins and the narrowing gap between cost and price becomes crucial. This affects the medium-term return on equity outlook, requiring sustained growth to offset the impact.

On the deposit front, savers may benefit from improved fixed deposit rates as banks adjust to the increased cost of funds. This is positive for senior citizens and retirees relying on interest income. Further hikes in deposit rates are likely if liquidity tightness persists. In summary, investors could consider accumulating high-quality bank stocks during market declines, especially those with strong liability franchises.

Impact on Industries 

The tightening liquidity and rising interest rate environment have different impacts on various industries. Sectors sensitive to interest rates, such as housing, auto, and infrastructure, may experience pressure on discretionary demand as financing costs rise. However, banks competing to mobilize low-cost deposits might find some relief in offsetting wholesale funding pressures.

The stable growth of CASA deposits and retail term deposits becomes a key battleground for banks. While this aids the sustainability of credit offtake, the liquidity deficit prompts a cautious lending approach for banks and non-banking financial companies (NBFCs), impacting loan sanctions.

In the bond markets, higher yields may attract foreign investors reallocating capital, providing support for the rupee and mitigating imported inflation risks. The overall approach should involve a balance between growth and inflation risks, allowing economic participants time to adapt.

Long Term Benefits and Negatives 

From a long-term perspective, the current tight liquidity phase allows the RBI room for a pause in benchmark rate hikes, letting the transmission of previous hikes run its course. This prevents over-constrained resources from jeopardizing the revival of economic growth.

Higher borrowing costs incentivize efficient capital allocation across industries, driving productivity gains. Banks focus on high-quality originations, improving financial stability over multiple economic cycles. However, inadequate liquidity risks hindering access to affordable credit for small businesses and poorer households, delaying financial inclusion and straining job creation.

For the RBI, projecting cash conditions remains challenging, and avoiding liquidity forecast errors is crucial for policy efficacy. Striking a balance between growth and inflation amid fiscal uncertainties and global factors requires a multi-indicator assessment for policy flexibility.

Short Term Benefits and Negatives 

In the short term, elevated funding costs compress bank margins, impacting earnings until full asset repricing completes over 2-3 quarters. Retail investors should focus on management commentary regarding funding stability, deposit momentum, and the projected Net Interest Margin (NIM) trajectory.

Higher deposit rates offer income investors better returns between rate hike cycles. Optimizing the mix of short-medium bucket fixed deposits aids portfolio construction. For lending institutions, operating processes undergo changes to accelerate repricing ability through dynamic linking to market benchmarks.

While margins remain in transition, growth impulses require insulation from excessive conservatism. Guarding nascent Capital Expenditure (Capex) revival retains priority, and banks must balance prudence and support amid the current flux.

In conclusion, the RBI must provide transparency on its liquidity management strategy to address near-term uncertainty, while banks balance prudence and support in a dynamically changing environment.

Potential Impact of Tight Liquidity on Different Companies:

Indian Companies Likely to Gain:

  • Non-Banking Financial Companies (NBFCs): Increased borrowing costs for banks could make NBFCs a more attractive source of financing for businesses, potentially boosting their demand for loans. Companies like Bajaj Finance Ltd.HDFC Ltd., and Mahindra & Mahindra Financial Services Ltd. could benefit from this shift.
  • Debt-free Companies: Companies with strong balance sheets and minimal reliance on debt financing will be less impacted by rising interest rates and might outperform the market. Examples include Infosys Ltd.Pidilite Industries Ltd., and Asian Paints Ltd.
  • Government Bonds Market: Increased demand for government securities as banks replenish their LCR buffers could benefit the government debt market and lead to higher bond prices. This could be favourable for investors holding existing government bonds or those actively trading in the market.

Indian Companies Likely to Lose:

  • Banks: Tight liquidity and rising funding costs will squeeze banks’ net interest margins (NIMs) as their cost of lending increases while deposit rates might lag. This could impact the profitability of major banks like HDFC Bank Ltd.ICICI Bank Ltd., and Axis Bank Ltd.
  • Interest-Rate Sensitive Sectors: Companies in sectors heavily reliant on borrowing, such as real estate, infrastructure, and automobiles, could see their growth hampered by higher loan costs. Companies like L&T Ltd.Tata Motors Ltd., and DLF Ltd. could face challenges.
  • Small and Medium-sized Enterprises (SMEs): Access to finance could become more difficult for SMEs due to banks’ focus on larger borrowers and higher risk aversion. This could impact their growth and business operations.

Global Companies Likely to Gain:

  • Foreign Institutional Investors (FIIs): Higher yields on Indian government bonds could attract foreign investment due to increased returns compared to other markets. This could lead to positive inflows for the Indian Rupee.
  • Global Debt Investors: Rising bond yields globally could create a more attractive environment for investors seeking higher returns. This could benefit global asset managers and investment banks involved in international bond markets.

Global Companies Likely to Lose:

  • Emerging Market Investment Funds: Funds primarily invested in emerging markets like India could face pressure due to concerns about rising interest rates and potential economic slowdown. This could lead to outflows from emerging market funds.

Market Sentiment:

Overall, the news of tight liquidity in the Indian banking system is likely to create a mixed sentiment in the market. While some sectors and companies might benefit from specific opportunities, others could face challenges due to higher borrowing costs and economic slowdown concerns. Investors are likely to adopt a cautious approach and focus on defensive sectors and high-quality stocks with strong fundamentals.

Important Note:

It’s important to remember that these are just potential impacts based on the available information. The actual effects on individual companies and the overall market might differ depending on various factors like the duration and extent of tight liquidity, future policy decisions by the RBI, and overall economic conditions.

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