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Credit costs contained, NIMs poised to expand

The RBI’s shift to a tightening cycle, with a 25 bps repo rate hike and a more hawkish stance, reflects rising inflationary pressures and points to further rate increases ahead. While higher rates typically raise concerns around growth and asset quality, we believe the current cycle poses limited risk, given healthy balance sheets, tighter underwriting standards in recent years, and stronger borrower fundamentals. Asset-quality risks remain contained, while frontline private banks are best placed to benefit through NIM expansion, supporting the potential for earnings surprises despite slower loan growth.

Rate cycle begins its upward climb

The RBI raised the repo rate by 25 bps to 5.5% and shifted its stance to ‘calibrated tightening’ from ‘neutral,’ effectively signaling further policy tightening ahead. The move was driven by a firmer macro outlook and higher inflation forecast. It strengthens the case for additional rate hikes despite the likelihood of a relatively shallow tightening cycle. Our base case remains for a further 50 bps of hikes over the next two policy meetings, taking the terminal repo rate to 6.0%, although persistent food and energy shocks could extend the hiking cycle beyond our current expectations.

Underwriting discipline provides a cushion against higher rates

While rising rate cycles are often viewed with caution given their impact on growth and asset quality, we believe the current cycle poses limited risk. Historically, rate-tightening episodes driven by global inflation and liquidity dynamics have had a smaller bearing on credit costs than cycles preceded by prolonged domestic credit excesses. The sector enters this phase with healthy balance sheets, having already tightened underwriting standards following regulatory concerns around unsecured lending during FY2023-24. We see limited evidence of any build-up in credit risk and believe most portfolios are well positioned to absorb higher rates. Furthermore, incremental credit growth in recent quarters has been led by corporates, whose balance sheets remain significantly stronger than in prior cycles. While we do expect loan growth to moderate, we believe the slowdown will be driven less by higher interest rates and more by the normalization of elevated credit demand seen after the Middle East crisis, which had supported short-term financing requirements across segments.

Frontline banks remain best placed to monetize the changing rate cycle

The structural shift in balance sheets, with increasingly pro-cyclical loan yields supported by fixed-rate deposits, should drive NIM expansion for banks, especially the large private banks, even if the expected rate cycle is relatively shallow. While our estimates do not yet fully reflect the impact of FCNR deposit repricing, we see scope for positive earnings surprises as margin tailwinds play out. Coupled with resilient asset quality and still-healthy growth prospects, this reinforces our preference for frontline private banks as the best way to position for the next phase of the banking cycle.

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