Andy Mukherjee is a Bloomberg Gadfly columnist covering industrial companies and financial services. He previously was a columnist for Reuters Breakingviews. He has also worked for the Straits Times, ET NOW and Bloomberg News.

Indian bank investors are in for a rude shock, and one that's got little to do with the chaos unleashed by demonetization.

The fault lies in shareholders' own expectations, which, in Morgan Stanley's words, are driven by "institutional memory." The top three Indian private-sector lenders by assets -- ICICI Bank Ltd., HDFC Bank Ltd. and Axis Bank Ltd. -- have such a stellar record of boosting their net interest margins (what they earn on assets minus what they pay for liabilities, divided by interest-earning assets) that it's almost unthinkable the profit gear could now be in reverse.

Defying Gravity
India's top three private-sector lenders have consistently boosted their net interest margins to a point where investors underestimate the likelihood of a compression
Source: Bloomberg
*Data are for standalone banks.

But in reverse it might well be.

Corporate loans have all but stalled, and with banks piling into retail lending, yields on personal advances are down 250 basis points over the past 12 to 18 months while loans against property have become 300 basis points cheaper.

On the deposit side, customer loyalty has turned fickle. A Bernstein survey shows that 84 percent of people are willing to open a new account to get more juice out of their savings. New banks like Equitas Small Finance Bank Ltd. and RBL Bank Ltd., as well as older but smaller lenders such as Kotak Mahindra Bank Ltd. and Yes Bank Ltd., are offering more lucrative rates than the big three. Digital wallets like Paytm, meanwhile, are looking to expand into wealth management.

The private-sector lenders, which disrupted the state's stranglehold on banking, are now staring at disruption themselves, according to Bernstein analyst Gautam Chhugani, who estimates that HDFC Bank, ICICI and Axis will expand their combined pre-provision operating profit by just 32 percent over the next three years as they sacrifice margins to gain market share.

Under Pressure
Margin squeeze in a slow loan growth environment may curb profit expansion to just 32 percent over three years, Bernstein estimates
Source: Bernstein

After a sixfold increase in operating earnings over the past decade, this would be a significant slowdown.

Among the trio, HDFC Bank is perhaps the best placed to weather competition: It does as much credit-card business as three of its nearest rivals put together. Even then, its exceptional track record of 29 percent annual average earnings growth over nearly two decades is perhaps now for the history books. This week, HDFC disclosed that it had let go of 4,500 employees in the December quarter, the most in any three-month period, according to the Economic Times.

As for ICICI and Axis, the jam could be a lot sticker. It might be time for investors to stop waiting for a clean up of nonperforming assets on their corporate loan books and start worrying about the upcoming erosion of margins.

Morgan Stanley this week pared allocations to HDFC Bank and Axis in its model Asia banking portfolio, and raised the weight of Hong Kong lenders. While asset quality is still an issue in India, compression of net interest margins is the bigger theme, the investment bank said.

The cornucopia of bank deposits since the Nov. 8 ban on high-value currencies may be masking the challenge, but a new kind of ugly is coming. In India, the better lenders may have it the worst.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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