The recent interest rate cut by the Federal Reserve in the US has raised expectations that India’s Reserve Bank of India (RBI) may follow suit in the coming months. Although the RBI has made it clear that controlling inflation is its priority, a gradual reduction in interest rates is expected in the second half of the financial year. If the RBI lowers rates by 25 basis points twice, the cost of funds for both banks and Non-Banking Financial Companies (NBFCs) will reduce. But, how will this impact the profitability of banks and NBFCs differently, and which sector could be a better investment?
How Interest Rate Cuts Impact Banks and NBFCs
When interest rates decrease, the cost of funds for financial institutions like banks and NBFCs goes down, meaning it costs them less to borrow money. This sounds positive for both sectors, but their earnings and growth are impacted differently.
Banks Under Pressure
Banks, especially in recent years, have enjoyed strong profits due to rising demand for loans, high net interest margins (NIM), and relatively low credit costs. For instance, the return on assets (RoA) of Scheduled Commercial Banks (SCBs) was 1.3% in FY24, and their return on equity (RoE) reached 13.8%. Large private banks performed even better, with an RoA of 2%.
However, the lending environment has been getting tougher for banks. The RBI has been tightening regulations, especially on unsecured loans, which has made it harder for banks to sustain high lending rates. Additionally, fierce competition in the banking sector has squeezed profit margins.
Another challenge for banks is that their net interest margin has been under pressure for the past two quarters. The deposit rate has gone down to 6.48%, while the lending rate stands at 9.40%. If this trend continues, banks may find it difficult to maintain the same levels of profitability.
NBFCs Are Set to Benefit More
NBFCs, on the other hand, seem to be in a stronger position to benefit from falling interest rates. There are several factors working in favor of NBFCs:
- Stronger Balance Sheets: The balance sheets of many NBFCs are now more robust, with their leverage ratio dropping from a high of 4.5x to 3.1x. This gives them more room to raise funds at lower costs as interest rates decline.
- Improved Asset Quality: The asset quality of NBFCs has significantly improved. The net non-performing asset (NNPA) ratio is at a historical low of 1.1%, reducing the risks associated with bad loans.
- Reduced Credit Costs: The credit costs for NBFCs have also decreased in recent years. However, it’s important to note that credit costs may increase in the medium term as more loans are issued.
- Better Funding Options: NBFCs have benefited from a fourfold increase in bank loans over the past seven years. With interest rates falling, NBFCs will find it easier to raise funds without putting pressure on their NIM, unlike banks.
What Should Investors Do?
Given these factors, NBFCs appear to be better positioned to benefit from the expected interest rate cuts compared to banks. As their funding costs go down, NBFCs can maintain profitability without the same pressures on NIM faced by banks. Moreover, the valuation of some NBFC stocks is currently attractive, and as interest rates decrease, their valuation multiples are likely to rise.
For investors looking to take advantage of the anticipated reduction in interest rates, NBFCs could provide better returns than banking stocks. While banks face increased competition and tightening regulations, NBFCs are poised to take advantage of lower borrowing costs, making them a more attractive option in the current financial climate.
Investors should evaluate their portfolios and consider adding NBFC stocks to capitalize on this shift.
