Why the sell-off in Axis Bank’s shares on NIM compression fears is overblown

This is because markets look forward. Investors use reported results pertaining to the immediate past to guesstimate future results. Right now, investors are seeing a potential future drag across the financial sector, and this is leading to caution about BFSI stocks.

Interest rates are up and may rise further, with inflation running high. Liquidity is down, meaning banks have less in the way of surplus funds to lend. Both those trends have negative implications.

One key banking ratio is the net interest margin or NIM. This is the difference between the interest paid by the bank to borrow money (tied to the deposit rates banks offer) and the interest they charge borrowers. The wider the NIM, the better. If liquidity tightens, banks raise deposit rates to attract funds, and the cost of funds rises. The NIM tightens.

If interest rates are on the rise, banks also have to mark down the value of existing loans. A loan that yields let’s say, 10% is less valuable than a loan that yields 11%. That’s reflected in the mark-down. Similarly, a government treasury bill or a corporate bond that yields 10% is less valuable than one that yields 11%. Hence, banks can also suffer trading losses in bond and treasury markets – treasury income can fall or go negative when rates rise. Axis suffered such trading treasury losses in Q2 and made profits in Q3. In addition, lenders may suffer a reduction in credit demand since potential clients are more reluctant to take loans when rates rise.

Faced with very high inflation, the RBI hiked interest rates in May, even though a meeting of the Monetary Policy Committee which decides on such matters, wasn’t due till June. The central bank has since continued to hike policy rates, raising by an aggregated 2.25 percentage points between May and December. RBI has also tightened liquidity through other means at its disposal.

Simultaneously, credit demand has increased as the post-pandemic economic recovery has continued. Credit demand hit a 10-year high between April and September, and the credit-deposit ratio (loans as a percentage of deposits) is also at a four-year high.

Another pressure point is the high fiscal deficit. Governments (states and Centre) need to borrow and given a pre-election year, you can expect an expansion in politically driven spending. That demand will further tighter liquidity.

In the early stages of such a rate-hike cycle, banks benefit. They raise lending rates while holding deposit rates steady. This helps expand net interest margin. However, as liquidity tightens, they are forced to offer higher deposit rates and the NIM drops.

Banks also have other fee-based incomes from credit card fees, processing charges for mortgages, fees for portfolio management and advisory services, etc. They may have subsidiaries (such as mutual funds) which pay dividends. They may be channels for cross-selling insurance products for commissions. These incomes correlate with economic activity, so other income has risen.

Opinions differ on the RBI’s likely monetary policy in 2023. Some expect the RBI to continue raising policy rates in February, post-Budget. Others suggest the central bank may hit the pause button. However, nobody thinks the RBI will cut rates.

Most of the key numbers Axis reported were healthy. Profits were up 62%. The NIM expanded, was up 30 basis points and Net interest income (total interest income minus total interest paid) was up 32% from a year earlier. Treasury income was up. Other income was up 22%, with a 23% rise in fee incomes plus treasury profits of ₹428 crore. The quantum of all loans rose by 15%, with the major contribution coming from a 9% rise in corporate loans.

While bad loans rose slightly, the ratio of bad loans to all loans (known as the net NPA ratio) was down, and there was ample provision for writing off bad loans or non-performing assets (NPAs) as these are known.

Provisions for bad loans increased slightly, and the credit cost (a measure of losses caused by write-offs of bad loans) was 0.65%. The Net NPA ratio (bad loans not covered by provisions, as a percentage of all loans) declined to 0.47%, while the provision coverage ratio was 81% (provisions as a percentage of estimated bad loans). These are all healthy numbers.

Therefore, the drop in share value is likely caused by fears of future NIM compression as deposit rates are being forced up. This sell-off might be an over-reaction given that analysts who follow the banking sector closely are all positive about the future prospects of Axis Bank.