Public sector banks, burdened with expensive deposits raised at the peak of the credit crisis and rising bond yields, are unlikely now to fall to government pressure to further soften rates.
The government is seeking to adopt the measures that China and other Asian economies had introduced to lift the limits on bank lending in order to boost the economy.
According to analysts, profitability and margins of public sector banks could be under pressure particularly if specific Indian banks pursue a very aggressive growth strategy.
Meanwhile, shares in the State Bank of India gained 32 per cent this year, a figure that lags a 46 per cent gain in the bank index and a 57 per cent leap in shares of privately held ICICI Bank. About a quarter of all loans are controlled by SBI and its associates, and state-run banks control 55 per cent of all banking assets.
SBI slashed its deposit rate by 25 basis points as it reduced rates for a fourth time in 2009, but has not reduced its lending rate.
With the growth of bank loans slowing sharply, policy makers fear that the economic revival may suffer if the deep cuts in official rates are not passed on to the customers
The Reserve Bank of India has already cut its main lending rate by 425 basis points since October and state-run banks have cut their lending rates by 150-200 bps.
With falling loan growth, finance minister Pranab Mukherjee has urged banks to follow the central bank and reduce their interest rates.
But, according to bankers, more deposit rate cuts would lead to a flight of money from bank deposits to federal schemes that offer an attractive 8 per cent tax-free rate.
According to a banking industry body, banks would have been at the crossroads had they kept cutting their deposit rates - they would not get funds and without resources, they would not be able to lend.
According to research data, these schemes have lost heavily to bank deposits which account for 55 per cent of household schemes at March 2008.
Private sector lenders such as HDFC Bank and ICICI Bank, though not directly under government pressure, would still need to keep an eye on state-run banks and follow them to some extent to retain customers.
Analysts estimate a 10-20 bps drop in margins in the next two quarters after a 40 bps March quarter fall.
Another factor that the banks worry about is the rise in bond yields. Banks are required to park roughly a quarter of their deposits in bonds and benchmark yields are up this that puts margins under pressure. According to bank officials, it is not possible to have a situation in which bank deposit rates are falling and benchmark yields are rising.