Indian banks are expected to experience a slight dip in their net interest margins (NIMs) in 2025-26, with an average decline of 10 basis points. This forecast follows the Reserve Bank of India’s (RBI) recent decision to cut interest rates, although the decline will likely be tempered by the RBI’s proactive measures to ease liquidity conditions, according to Fitch Ratings.

The RBI initiated its rate-cutting cycle last week, lowering the key policy rate by 25 basis points to 6.25 percent. The central bank also committed to remaining watchful, actively managing liquidity, especially since the banking system has been dealing with a liquidity deficit for the past two months.

Impact of Rate Cuts on Loan Markets

The immediate impact of these interest rate cuts will be most noticeable in floating-rate loans tied to external benchmarks, such as housing and small and medium enterprise (SME) loans. The effect will also be felt in the broader loan market, particularly on new loans issued in an environment of declining policy rates.

Fitch Ratings warned that non-bank financial institutions (NBFIs) could also see pressure on their NIMs, especially in segments where they compete with banks, such as near-prime urban housing and commercial loans.

Short-Term Pressure on NIMs

While loan rates will adjust quickly to the rate cuts, analysts expect a short-term hit to banks’ NIMs, as repricing of deposits tends to lag behind loan rate changes. Despite this, the banking sector’s NIM remained healthy at 3.5 percent between April and September 2024, although it had dropped slightly from 3.6 percent in the previous fiscal year. The dip was primarily driven by the upward repricing of deposits in response to tighter liquidity conditions.

Outlook for 2025-26: Slower Growth and Lower Yields

Fitch expects that Indian banks’ NIMs will trend closer to the long-term average of about 3 percent due to slower loan growth and lower yields. The agency added that if tight liquidity conditions prevent banks from adjusting their deposit costs in line with the falling policy rates, NIMs could narrow more quickly than anticipated.

Liquidity Conditions Provide Short-Term Support

The Indian banking system’s liquidity saw a significant increase in January, hitting over Rs 3 trillion ($34.31 billion), and remained above Rs 2 trillion in mid-February. Fitch noted that banks might receive short-term support from delayed deposit runoff rates and expected credit losses, which are not likely to materialize until after 2025-26.

While Indian banks face a challenging period with a decline in NIMs in the wake of the RBI’s rate cuts, the easing of liquidity conditions and proactive measures from the central bank may help mitigate some of the impacts. However, the extent of the pressure on banks’ margins will depend on how quickly they can adjust deposit rates and manage their loan portfolios.

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