Continuing from yesterday (see here).
In my previous post, I invited investors’ attention to the impact of banking sector underperformance on their portfolios and a need to carefully assess the challenges being faced by the Indian banking sector presently, particularly from the growth and valuation viewpoints.
The following points, for example, make this review pertinent in my view.
Credit and Deposit need a close watch
At first glance, the credit data is impressive. Bank credit grew at 16% year-on-year to reach Rs 219 lakh crore as of March 31, 2026. Deposit growth came in at 13.4% to reach Rs 267.8 lakh crore. The headline numbers are healthy.
But dig a little and the picture gets more complicated. As recently as mid-FY26, the credit-deposit gap had widened to 263bps, with credit growing at 12% while deposit growth slipped to just 9.35%. The credit-to-deposit ratio, which stood at 53% in 2000-01, has now climbed to 82% — a multi-decade high. This means banks are increasingly stretching their deposits to fund lending.
More importantly, look at where the stress is building. Unsecured personal loans and credit card borrowings, which had been growing at CAGRs of 22% and 25% respectively in the three years to FY24, have slowed sharply — to 11% and 18% — after the RBI tightened risk weights. That is the right policy move, but it means the high-margin, high-growth engine of retail banking is now running at a lower speed. Stress in unsecured retail loans accounted for roughly 52% of new bad retail loans in the first half of FY25.
The home loan market is stable and growing, but competition has crushed spreads. Every major bank now offers floating rate home loans linked to the repo rate, with 50–75 basis point cuts being passed on almost immediately. In the rush to grow the mortgage book, margins on this segment are getting thinner every year.
Real estate sector lending has picked up, but commercial real estate and construction loans carry higher provisioning requirements under the Expected Credit Loss (ECL) framework that banks are now transitioning to. This transition is a key monitorable that the market seems to be ignoring.
The Cost Line is Getting Harder to Control
Banking is supposed to be an operating leverage play — as business grows, costs grow slower, and profits grow faster. That story worked beautifully from 2020 to 2023. It is now becoming complicated.
Employee costs remain sticky. The top private banks have been expanding branch networks aggressively — including HDFC Bank’s massive post-merger expansion — and with that comes increased headcount, salaries, and retirement benefit obligations. Wage settlements with unions at public sector banks add another layer of fixed cost increases every few years.
“Despite a nearly five-times increase in information technology spending of banks over the last decade, actual productivity gains for Indian banks have been just 1%.” — BCG Report, August 2025.
The AI and technology cost story is particularly worth examining closely. Banks are spending heavily — the Indian banking sector’s IT spending is projected at $14.5 billion in 2025. A BCG report noted that IT costs have grown at a CAGR of 17.4% over the decade to FY25, leading the pack in operating expense growth. In other words, tech spending is rising fast, but the productivity payoff is still modest.
Generative AI adoption is now accelerating in earnest. Banks are deploying voice bots, workflow automation, AI-powered credit underwriting, and fraud detection. The EY-estimated productivity gain from GenAI is 34–46% by 2030 — a promise, not a delivered result. Until then, banks must spend to build these capabilities. The incremental IT capex through FY27–28 will be substantial before the savings materialize. Think of it as a valley before a hill.
The net effect: operating expense ratios are unlikely to compress meaningfully in FY27. Margins from efficiency gains remain a story for later.
Asset Quality Is Near Its Best — That Means It Can Only Stay or Worsen
Indian banks have done extraordinary work cleaning up their balance sheets. Gross NPAs, which peaked at a distressing 11.2% in FY18, have fallen all the way to 2.0–2.1% by March 2026 — a near two-decade low. Net NPAs are at just 0.5%. These are genuinely good numbers.
But here is the investment catch: when you start from a place of historically good asset quality, where exactly do you go from here?
Crisil projects gross NPAs will be range-bound at 2.0–2.2% by March 2027. MSME stress from global trade disruptions (including the West Asia conflict and US tariff volatility) is already being flagged. The RBI’s own stress tests indicate NPAs could inch back toward 3% in adverse scenarios. Recovery-driven earnings tailwinds are now largely behind us.
For years, banks benefited from lower credit costs — the money set aside for potential loan losses. As NPAs fell, provisioning requirements fell with them, giving a boost to profitability that was not really “operational” in nature. That one-time tailwind from improving asset quality has now run its course.
Meanwhile, the transition to Expected Credit Loss (ECL) norms — a more forward-looking provisioning framework that the RBI is phasing in — means banks will be required to set aside provisions for loans that are still performing but carry elevated risk. This could require a meaningful one-time uplift in provisions and suppress near-term profitability, even if banks’ underlying credit health is fine.
In the retail segment, stress from over-leveraged borrowers holding multiple unsecured loans is clearly visible. Borrowers with three or more personal loans are showing higher default rates. Credit cards outstanding and small ticket personal loans — the highest-yield part of banks’ retail books — are also the highest-risk segments today.
Net Interest Margins Have Peaked — The Rate Cycle Is Not a Friend Right Now
The RBI has been on a rate-cutting cycle, with cumulative cuts of 125 basis points in 2025 alone and further cuts likely in FY27. Lower rates are good for borrowers and for credit growth — but they compress what banks earn on their loan books.
NIMs (Net Interest Margins — the difference between what a bank earns on loans and what it pays on deposits) have already been under pressure. ICRA noted that the December 2025 rate cut delayed NIM recovery to at least Q1 FY27. HDFC Bank’s CASA ratio dipped to 34.14%, down from 34.79% last year — indicating that cheaper deposits are getting replaced by higher-cost term deposits as savers chase better rates from fixed deposits.
In this environment, the NIM compression story is unlikely to reverse quickly. Banks will see some relief as deposit repricing happens on the way down, but this takes quarters to fully work through. Meanwhile, competitive pressure in lending rates — especially in home loans and corporate credit — keeps asset-side yields under check.
Simply put: margins have seen their best levels. The next 12 months are likely to see flat to marginally lower NIMs, which directly hits the profitability narrative.
Fee Income Is Getting Squeezed by the Regulator
Banks have historically supplemented their interest income with a wide range of fees — distribution of mutual funds and insurance, processing fees, forex income, card-related charges, and the like. Many of these are now under regulatory pressure.
UPI transactions carry zero MDR — neither the merchant nor the bank earns a fee on these. As UPI volumes have exploded into the billions of transactions per month, this zero-MDR policy has effectively eliminated a significant revenue pool. RuPay debit card transactions also carry no MDR. Banks absorb the infrastructure cost of maintaining these payment networks without a corresponding fee income.
There is ongoing debate about whether a modest MDR should be introduced for large-value UPI transactions. But the political economy of reversing zero-MDR — a policy celebrated as a win for digital inclusion — is very difficult.
The RBI has also been tightening the screws on mis-selling of insurance and investment products, bancassurance practices, and customer fee disclosures. Each of these tightening moves reduces the scope for high-margin fee income that banks had been growing aggressively over the past decade.
Banking Products Are Getting Commoditized
This is perhaps the most structural and underappreciated risk of all.
Think back to the 1990s and early 2000s. ICICI Bank was known for project finance and capital markets. HDFC Bank was the pioneer in salary accounts and consumer banking. Kotak was the equipment financing specialist. Foreign banks like Citibank dominated private banking and credit cards. Each institution had a genuinely differentiated identity.
Now visit the website or app of any of the top 15 banks. They all offer:
• Credit cards with airport lounge access and cashback
• Personal loans in under 60 seconds
• Home loans at competitive floating rates
• MSME loans with digital underwriting
• Savings accounts with high interest rates (with conditions, of course)
• Mutual fund and insurance distribution
• AI chatbots and digital-first platforms
When financial products are commoditized, the competitive edge shifts to cost of funds, distribution scale, and brand trust — all of which tend to favor the largest players and erode the pricing power and growth premium of mid-sized private banks. The niche differentiations that once justified large private banks trading at 4-5x their book value are rapidly disappearing.
The AI/tech convergence is actually accelerating commoditization, not reversing it. Every bank has cloud infrastructure. Every bank has a chatbot. Every bank has instant loan disbursal. Technology was supposed to be the moat — instead, it is becoming a minimum requirement, a table stake rather than a differentiator.
The investment question then becomes: if banking is increasingly a commodity business, why should private banks trade at 3x–4x price-to-book when global banking peers trade at 1x–2x? The valuation premium is a legacy of the differentiation era. As that era fades, so should the premium.
What Does This Mean for Bank Nifty vs. Nifty 50?
Bank Nifty already underperformed Nifty during the period 2021 to 2024. The Nifty Bank rose 41% from September 2021 to September 2024, against a 47% rise in Nifty 50 — this despite banking sector EPS growing 135% versus 77% for Nifty companies. Superior earnings, inferior stock performance. That is a classic de-rating play book — the market awarded a lower multiple to the same rupee of bank earnings.
The setup for the next twelve months is similar, and in some ways worse:
• Earnings growth for banks is likely to moderate as NIMs stabilize at lower levels and credit cost tailwinds dry up.
• The sectors most likely to outperform Nifty — capital goods, infrastructure, pharmaceuticals, defence, new-age technology — carry earnings growth visibility that banks simply do not have today.
• Global tariff and trade uncertainty disproportionately hurts MSME credit quality, a growing portion of bank books
• Regulatory tightening (ECL norms, fee income restrictions, UPI zero-MDR) keeps compressing profitability without a clear reversal in sight.
• The valuation premium for private banks, while partially corrected, still has room to compress as commoditization plays out.
To be clear — I am not arguing that bank stock may correct sharply, or that their fundamentals are broken. Indian banking is structurally sound. Credit demand is real. NPA levels are the best in two decades. Capital adequacy is comfortable at 17.24% system-wide. These are not the conditions for a banking crisis.
I am making a narrower, more specific argument: the easy money in banking stocks has been made. The sector is now priced for outcomes that will be hard to deliver. In a market where capital flows will increasingly chase sectors with genuine earnings acceleration — and banking might not be among them in FY27 — Bank Nifty’s relative underperformance versus Nifty 50 is the most likely outcome.
The Bottom Line
Banking stocks had their moment — and it was a good one. Clean balance sheets. Record profitability. Massive re-rating. But each of those drivers has now run most of its course.
What lies ahead is a period where deposit growth lags credit, margins are flat at best, AI spending front-runs the productivity savings, fee income is regulated away, and the valuation premium for differentiation gets questioned because the differentiation itself is fading.
If you’re holding a Nifty index fund, you’re indirectly holding about 25–30% of your money in banks and financial companies. That’s probably fine. But if you’re actively overweight Bank Nifty or banking stocks relative to Nifty — this might be a good time to ask yourself: what is the specific catalyst that will drive banks to outperform from here?
I failed to find a compelling one over the next twelve months.
No comments:
Post a Comment