The ongoing sharp reduction in lending rates will not be margin dilutive for the banks but rather help them tide over the bad loans pains as it will help the struggling corporates begin to pay back their loans, says a report by leading Wall Street brokerage Jefferies.

"We don't think the 30-90 bps MCLR reduction by banks led by SBI is margin dilutive for the banks. In the shorter term of one to two quarters, we don't think these reductions could be NIM-dilutive, and even if it is, it would be relatively small," Jefferies said in a note on Wednesday.

Explaining its contrarian view, the brokerage said the "implication of the rate cut on corporate profitability and improvement in interest coverage ratio (ICR) can be material for certain corporates given the extent of MCLR cuts and hence the bad loan outlook can turn slightly better for the banks." 

It also argues the fundamental difference between base rate and MCLR is that under the latter, banks have the ability to choose 'interest reset dates' and as a result, an MCLR increase/cut doesn't translate to a higher or lower borrowing cost soon for customer as it happens over a period of time.

Following the Prime Minister's indirect nudge on the New Year's eve, banks led by State Bank, PNB, Union Bank and HDFC have slashed their marginal cost of funds based lending rates between 30 and 90 bps. SBI cut it the maximum of 90 bps.

The report also said since most banks were maintaining a 60-90 bps spreads since the MCLR regime to into being, it was clear that banks would pass on the cheaper deposits benefit to lower lending rates.

Large accretion to Casa deposits after tje noteban and caps on withdrawal have sharply lowered overall cost of funds for banks. SBI, which as collected over Rs 1.65 trillion in Casa deposits, has even cut its base rate by 5 bps.

However, rate cut is ngative for NBFCs, especially for those dependent on wholesale/bond market financing, as they could likely face a squeeze in spreads on incremental volume.

This is more so as post-demonetisation, the generic AAA rated one-year bond yield has come down by only 15 bps, but a 60-90 bps reduction in one-year bank loans rate, can shift the marginal volume from a non-bank to a bank.

"While we believe in this scenario banks will outperform NBFCs, and therefore retain our cautious stance on the banking sector, we remain broadly positive on corporate banks over a medium term perspective given their cross-cycle valuation and outlook," the report said, adding its top picks are ICICI Bank, Axis Bank, HDFC Bank from the private sector portfolio and SBI from the state-run bunch.

As sluggish demand is the biggest risk to banks, it said demand revival is key for corporate and banking sector.

While bank credit to industries contracted to -3.4 per cent in November, credit to services grew 7.1 per cent. But what is important is that as much as 56 per cent of bank loans and 88 per cent of NPAs are with large borrowers.