After nearly three quarters of generosity , banks are now facing pressure to reduce deposit rates. Most face a margin squeeze with the rise in interest expenditure outpacing the increase in interest income at the start of the third quarter of the financial year.

Union Bank, a Mumbai-based public sector bank, has taken the lead. Irrespective of competitive pressures, the bank has cut rates on one-year deposits to 8.5 per cent from 9 per cent, the rate most banks are offering on one- and two-year deposits.

"The revision in deposit rates will help the bank contain the cost of resources and improve margins," said M V Nair, chairman, Union Bank.

Union Bank of India's [Get Quote] interest income grew 27 per cent during the quarter from a year earlier but its interest expenditure rose faster at 38 per cent. As a result, the bank's net interest margin (NIM) in the second quarter fell to 2.56 per cent, from 2.76 per cent a year ago.

Other banks are expected to follow suit. Banks like IDBI, ICICI Bank [Get Quote], HDFC Bank [Get Quote] and Vijaya Bank [Get Quote] have reported a sharper rise in interest expenditure than interest income in July-September 2007 from a year earlier.

ICICI Bank's interest income, for instance, grew 37 per cent while its interest expenditure rose by 47 per cent.

Most banks are waiting for the mid-term review of the Reserve Bank of India's monetary policy, due on October 30, before they take action.

"There is scope to reduce deposit rates 50 to 100 basis points but we are awaiting policy signals," said a senior IDBI Bank official. Analysts suggest that cutting deposit rates is a fait accompli.

"Irrespective of the policy signals, based on the observation of growth in interest earned and interest expended, it would be rational for banks to reduce deposit rates by 25 to 50 basis points across maturities," said Roopa Rege-Nitsure, chief economist, Bank of Baroda [Get Quote].

The sharp slowdown of credit growth will also require banks to cut deposit costs to sustain profit growth.

Since April 2007, bank credit grew only 5 per cent with just Rs 96,486 crore added to advances against Rs 1,54,000 crore a year earlier.

Poor credit off-take in the first half of 2007-08 has led to slower growth in banks' net interest earnings.