High exposure to repo-linked retail, agriculture and MSME loans could allow public sector banks to reprice assets faster than deposits if the RBI raises rates

Public sector banks (PSBs) could see some relief to their pressured net interest margins (NIMs) if the Reserve Bank of India (RBI) begins raising policy rates, as a significant portion of their retail, agriculture and micro, small and medium enterprise (MSME) loans is linked to external benchmark lending rates (EBLRs).

Since EBLR-linked loans are largely benchmarked to the repo rate, any increase in the RBI's policy rate can be transmitted to borrowers relatively quickly. Deposit rates, on the other hand, generally reprice with a lag, potentially creating a temporary improvement in the spread between lending yields and funding costs.

The issue has gained importance because most banks have already experienced pressure on NIMs, while the large mobilisation of foreign currency non-resident (bank), or FCNR(B), deposits through the RBI's concessional swap window could create additional pressure on margins in the near term.

RBI Rate Hike Expectations Gain Momentum

Market expectations have shifted towards the possibility of a shallow rate-hike cycle as inflationary pressures are expected to increase later in the financial year.

According to the Business Standard report, expectations are for cumulative rate hikes of around 50-75 basis points, with one scenario involving a 25-basis-point increase in October followed by another 25-basis-point increase in December.

Retail inflation increased to 4.82 per cent in August from 4.45 per cent in July, while economists cited in the report expect September inflation to rise further to around 5.5 per cent. Inflation is expected to peak at 6.1 per cent during the October-December quarter of FY27 before moderating in the following quarter.

The actual path of monetary policy, however, will depend on incoming inflation, growth, liquidity, currency and commodity-price data.

Why EBLR Loans Matter for PSBs

External benchmark-linked lending rates have changed the speed at which banks can transmit monetary-policy movements to borrowers.

When a loan is linked to the repo rate, a policy-rate increase can result in a corresponding increase in the lending rate according to the terms of the loan. This allows banks to adjust the yield on their floating-rate assets relatively quickly.

Deposits work differently. Banks may not immediately increase deposit rates following every policy-rate move, particularly where existing deposits continue to remain outstanding at previously contracted rates.

This difference in repricing speed can temporarily benefit NIMs.

For PSBs, the effect could be particularly relevant because of their relatively high exposure to retail, agriculture and MSME lending.

RAM Loans Account for More Than Half of PSB Advances

Data compiled from eight state-owned banks showed that RAM loans accounted for more than half of domestic advances at each of these lenders in Q1FY27.

Central Bank of India had the highest RAM exposure at 68.13 per cent of its loan book, followed by State Bank of India at 66.78 per cent and Indian Bank at 66 per cent.

Bank of Baroda's RAM exposure stood at 62.9 per cent, while Canara Bank was at 59 per cent. Bank of India, Punjab National Bank and Union Bank of India reported RAM exposure of 58.3 per cent, 57.2 per cent and 55.5 per cent, respectively.

The relatively high share means changes in benchmark-linked lending rates can have a meaningful impact on the asset side of these banks' balance sheets.

NIM Pressure Remains a Key Concern

Net interest margin is one of the most important profitability indicators for banks because it measures the difference between interest earned on loans and investments and the interest paid on deposits and other funding sources.

PSBs have already been dealing with margin pressure.

In Q1FY27, domestic NIMs ranged from 2.52 per cent at Canara Bank and Bank of India to 3.41 per cent at Indian Bank. SBI reported a domestic NIM of 3 per cent, while Central Bank of India and Bank of Baroda recorded 3.06 per cent and 2.93 per cent, respectively.

A faster repricing of loans could therefore provide some support if funding costs do not increase at the same pace.

FCNR(B) Deposits Create Another Margin Challenge

The potential benefit from loan repricing comes at a time when banks have received a large amount of foreign currency funding through the RBI's special FCNR(B) swap window.

Banks mobilised around $127 billion through the concessional swap facility, substantially increasing the availability of foreign-currency deposits within the banking system. The mobilisation window closed on August 31.

The inflows have strengthened banks' liquidity and deposit availability, but the large amount of funds also creates a deployment challenge.

Banks need to deploy the additional liquidity efficiently without compromising credit quality or lending discipline.

FCNR(B) Funds Could Compress NIMs in the Near Term

According to Kotak Institutional Equities, the FCNR(B) deposits could result in a near-term NIM compression of around 10-30 basis points because these funds take time to be deployed.

While the deposits improve the availability of funding and can help lower banks' credit-to-deposit ratios and funding costs, the benefit is not necessarily immediate.

Until the funds are deployed into earning assets, the additional liabilities can affect the overall margin profile.

This makes the timing of asset repricing particularly important for banks.

Rate Hikes Could Create a Temporary Margin Advantage

If the RBI raises the repo rate while deposit costs remain relatively stable, banks with a large EBLR-linked loan portfolio could see lending yields adjust before their funding costs rise proportionately.

This creates the possibility of a temporary margin reprieve.

A senior executive at a state-owned bank cited by Business Standard said a significant portion of the bank's RAM portfolio was linked to external benchmarks, meaning lending rates could respond relatively quickly to a policy-rate increase. Another PSB executive similarly highlighted the possibility of faster asset repricing than deposit repricing.

However, the benefit would depend on the magnitude and duration of the repricing gap.

Deposit Competition Could Limit the Benefit

The margin benefit from higher lending rates is not guaranteed to persist.

If banks subsequently have to raise deposit rates to retain deposits and compete for funding, the cost of liabilities could also increase. In that situation, the initial benefit from higher loan yields could gradually narrow.

This is particularly relevant in a banking system where credit growth and deposit mobilisation remain closely linked.

Therefore, investors will need to track both sides of the balance sheet rather than looking only at the potential increase in lending rates.

Credit Growth Will Remain Important

Another factor determining the impact of rate changes will be loan growth.

Higher lending rates can improve yields on existing floating-rate loans, but they can also affect demand for fresh credit if borrowers become more sensitive to borrowing costs.

PSBs therefore face a balancing act between protecting margins and maintaining healthy credit growth.

Retail and MSME borrowers may be particularly sensitive to changes in borrowing costs, while corporate credit demand could respond differently depending on investment activity and broader economic conditions.

Liquidity Conditions Are Also in Focus

The banking system has been operating with substantial surplus liquidity following the large FCNR(B) inflows.

The RBI has been using liquidity-management tools to influence system liquidity. Earlier this month, the central bank conducted variable-rate reverse repo operations, while market participants were also assessing the possibility of additional liquidity measures.

The liquidity backdrop matters because surplus liquidity can influence short-term money-market rates, deposit pricing and banks' incentives to deploy funds.

A combination of tighter liquidity and higher policy rates would have a different effect on banks compared with a rate hike occurring in an environment of abundant liquidity.

Bond Yields and the Rupee Add Another Layer

The banking sector is also exposed to developments in government bond yields and the currency market.

Higher bond yields can affect the valuation of banks' investment portfolios, although the accounting impact varies depending on how securities are classified and managed.

Meanwhile, movements in the rupee can influence foreign-currency funding and broader financial-market conditions.

Recent market data showed that FCNR(B) inflows and RBI intervention had contributed to stronger rupee conditions earlier in September, while global crude prices and US Treasury yields remained important variables for domestic markets.

What Investors Should Track in PSBs

For investors tracking public sector banks, the next few quarters could be particularly important for assessing the interaction between loan yields and funding costs.

Key indicators include:

• Movement in the RBI repo rate

• EBLR-linked loan exposure

• Deposit repricing and cost of deposits

• Domestic NIM trends

• RAM loan growth

• Credit-to-deposit ratios

• Deployment of FCNR(B) funds

• Slippages and asset-quality trends

• Loan growth and credit demand

• Government bond yields and treasury performance

The ability of individual banks to translate higher lending rates into improved margins will depend on their specific loan mix, deposit franchise and funding structure.

Different PSBs Could See Different Benefits

Although the broad theme applies across public sector banks, the impact will not necessarily be identical.

Banks with a higher proportion of EBLR-linked loans could see faster asset repricing, while lenders with higher funding costs or greater exposure to fixed-rate assets may experience a different outcome.

Similarly, banks with stronger low-cost deposit franchises may have more flexibility if competition for deposits intensifies.

Therefore, the headline expectation of a margin benefit from rate hikes needs to be assessed at the individual-bank level.

The Bigger Question: Can Margin Relief Offset Funding Pressure?

The key issue for PSBs is whether faster loan repricing can offset the margin pressure created by new funding and competitive deposit pricing.

The FCNR(B) inflows have improved liquidity and expanded banks' funding pool, but deploying those funds profitably without weakening underwriting standards remains important.

If loan rates reprice faster than deposit costs and credit demand remains healthy, NIMs could receive temporary support. If deposit competition intensifies rapidly or credit growth slows, the benefit could be significantly smaller.

Market Outlook

The outlook for public sector banks is increasingly tied to the direction of monetary policy, inflation and banking-system liquidity.

A potential rate-hike cycle could provide some near-term support to PSBs with large EBLR-linked RAM portfolios because lending rates can adjust faster than deposit costs. At the same time, the large FCNR(B) deposit mobilisation has created additional liquidity that banks need to deploy efficiently and could weigh on margins before the funds are fully utilised.

For investors, the focus should therefore remain on the repricing gap between assets and liabilities, rather than assuming that higher interest rates automatically translate into higher bank profitability.

The next few quarters will be important for determining whether faster loan repricing can offset funding-cost pressures. NIM movement, deposit pricing, credit growth, asset quality and the RBI's liquidity-management stance will remain key indicators for assessing the earnings trajectory of public sector banks.