The Indian banking sector is set to gain in 2025 as short-term borrowing costs are expected to drop. This decline can boost liquidity, increase profitability, and drive credit growth, reinforcing the financial system. The recent drop in short-term borrowing costs has proven beneficial for banks, leading to higher profitability and expanded lending. Financial institutions can reap several advantages with lower interest rates on short-term loans.
RBI’s Liquidity Boost and Its Impact on Borrowing Costs
1. Decline in Borrowing Costs
The announcement has already triggered a decline in certificate of deposit (CD) rates, with the one-month rate dropping by 15 basis points to 7.25% and the three-month rate falling by 10 basis points to 7.5% within a day. Additionally, the weighted average call rate eased to 6.55% from 6.57% in just 24 hours.
2. Relief for Banks Amid Tight Liquidity
Harsh Dugar, Executive Director of Federal Bank, highlighted that the RBI’s measures to address liquidity shortages will directly benefit banks by reducing short-term funding costs. The additional liquidity will also ease pressure on borrowing rates for financial instruments like CDs.
CDs (Certificates of Deposit), which are short-term debt instruments used by banks to raise funds, have become a crucial source of financing due to challenges in deposit mobilization. In 2024, banks raised a record ₹12.34 lakh crore via CDs, compared to ₹8.2 lakh crore in 2023.
3. Further Rate Adjustments Expected
According to VRC Reddy, Deputy General Manager – Treasury at Karur Vysya Bank, a significant shift in CD rates will be seen only after the RBI executes Variable Rate Repo (VRR) auctions or open market operations (OMO) next week. So far, the recent rate movements have been largely sentiment-driven.
4. RBI’s Multi-Pronged Approach
The RBI has announced several measures to address the liquidity crunch, including OMOs, VRR auctions, and dollar-rupee buy/sell swap auctions. The first OMO is scheduled for January 30, followed by the VRR auction on February 7.
Nomura analysts noted that while VRR is not a permanent liquidity injection, extending its duration will help banks with liquidity planning and reduce operational challenges.
5. Market Response
Following the RBI’s announcement, banking stocks surged 1-3% on the BSE. Shares of Canara Bank, IDFC First Bank, Punjab National Bank, and Bank of Baroda climbed 3%, while Axis Bank, ICICI Bank, and HDFC Bank gained around 2%.
Radhika Rao, Senior Economist at DBS Bank, emphasized that the RBI’s actions signal a comprehensive strategy to manage liquidity rather than a temporary fix. This move is expected to stabilize overnight rates, keeping them aligned with policy rates and ensuring financial conditions remain steady.
Factors Behind the Decline in Short-Term Borrowing Costs
The recent drop in short-term borrowing costs can be explained by several key factors:
- Monetary Policy Adjustments: The Reserve Bank of India (RBI) may cut interest rates to boost economic growth and stimulate investment.
- Enhanced Liquidity Conditions: An increase in the availability of funds within the banking system leads to reduced interest rates on short-term loans.
- Global Economic Trends: A more dovish approach to interest rates by central banks worldwide can influence lower borrowing costs in India.
- Government Measures: Government initiatives, such as fiscal stimulus packages, may also ease financial conditions and contribute to the reduction in short-term borrowing costs.
- Stable Inflation: A lower inflationary environment can lead to more favorable lending conditions, allowing interest rates to fall.
- Banking Sector Health: When banks are in a strong financial position, they can afford to offer lower rates to borrowers without compromising profitability.
These factors collectively contribute to the overall decline in short-term borrowing costs, benefiting both financial institutions and borrowers.
How Will Indian Banks Benefit from Lower Funding Costs?
- Reduced Borrowing Costs: Banks, that depend on short-term borrowing, will see improved margins on loans and financial products as costs decrease.
- Enhanced Lending Potential: Cheaper funds allow banks to extend more loans to businesses and consumers, stimulating economic activity.
- Improved Profitability: Lower interest expenses enhance net interest margins (NIM), resulting in better profits for banks.
- Optimized Liquidity Management: Banks will manage liquidity more effectively, minimizing dependence on costly funding options.
- Stronger Credit Growth: Lower rates encourage borrowing, driving increased credit demand from businesses and individuals.
Challenges and Risks of Declining Borrowing Costs
1. Pressure on Deposit Rates: As borrowing costs fall, banks may lower interest rates on deposits, which could affect savers’ returns.
2. Inflationary Risks: An influx of liquidity may create inflationary pressures, necessitating careful monitoring and intervention by the RBI.
3. Asset Quality Risks: While banks may increase lending, it’s crucial to manage credit risk effectively to prevent a rise in non-performing loans (NPLs).
4. Liquidity Management Challenges: Excessive liquidity, if not managed properly, can lead to inefficient fund utilization and potential instability.
5. Over-reliance on Short-Term Borrowing: If banks rely too much on short-term borrowing to fund long-term loans, they may face liquidity mismatches in the future.
Conclusion
The reduction in short-term borrowing costs creates a positive outlook for banks, allowing them to cut funding expenses, increase lending, and boost profitability. However, financial institutions must proceed with caution, ensuring effective risk management while taking advantage of the benefits of lower interest rates. In the long term, adopting a balanced approach will enable banks to maintain growth and support broader economic stability.
Sources: Banks to benefit from easing of short-term borrowing costs