Private Banks Have A Deposit Problem, And It's Likely Getting Ugly

Private banks, which have enjoyed higher valuations than their public sector peers, might see some constraints rise in their core business. A high credit deposit ratio is limiting their ability to make breakthroughs in business growth.

Moreover, public sector banks have the ability to raise rates on their lending portfolios owing to a structural difference in how their loans are benchmarked.

"This pricing dynamic could limit the growth outperformance of PVBs (vs. system/PSBs) and also add significant margin pressure in the medium term," analysts at Bernstein noted in their report on Tuesday.

Over the last few months, public sector banks have managed to raise their deposits much faster than private sector lenders. As of November 2023, the gap in fresh-term deposit rates between public sector banks and private banks was around 40 basis points.

While private banks have usually had lower deposit rates than public banks, their ability to play on a higher credit deposit ratio enabled them to outperform. Over the last 20 years, the average credit deposit ratio for private banks has risen from 70% to over 85%.

However, now, this advantage is starting to wane.

Currently, loan growth is around 16%, compared with deposit growth of 13%. For private banks, other than market leader HDFC Bank, this gap in credit growth would mean an incremental credit deposit ratio of 105%.

"Such a high incremental LDR (loan deposit ratio) is unsustainable. The best way to normalise would be a hike in lending yields and deposit rates that would drive equilibrium (higher deposit growth and slower lending growth) without hurting margins," Bernstein analysts said.

This, however, gets constrained because of the structure of loan books at public and private sector lenders. As private sector lenders have mostly moved their loan book to the external benchmark-linked lending rate, their ability to raise lending yields is limited.

In the case of public sector banks, 56.2% of the loan book is still linked to the marginal cost-based lending rate, allowing further repricing and protection of margins.

"This is probably what explains the aggressive term deposit pricing being seen from PSBs, as the slow hike in term deposit rates has resulted in near-stagnant MCLR levels for PSBs," Bernstein analysts said.

The Reserve Bank of India introduced benchmarking of lending rates to publicly available metrics such as the repo rate in 2019 to bring transparency in loan pricing. The older MCLR regime allowed banks to reprice their loans on the basis of their marginal cost structures.

A combination of tight liquidity and aggressive deposit pricing by public sector lenders could therefore result in slower deposit growth for private banks, which could constrain loan growth too.

A few factors may support private bank performance, though. These include a normalisation of credit growth, rising operational costs for public sector banks, and an uptick in low-cost current account savings account growth where private banks outpace their public sector peers.

"If the bear case does play out, it will require a relook at the private sector bank thesis and, more importantly, a change to the rank order. And in that bear-case scenario, smaller, nimbler franchises might be better positioned vs. the larger banks," Bernstein analysts said.