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FY26: A year of two halves

Earnings growth closer to an inflection point; NIMs to bottom out by 3QFY26E

* Against the market expectations of a shallow rate cycle just two quarters ago, RBI has implemented a sharp 100bp repo rate cut since Feb’25 and reduced the CRR by 100bp in four tranches starting Sep’25.

* While the 100bp rate cut will exert pressure on margins in the near term, the benefits from the CRR cut and gradual deposit repricing will mark a likely turning point for earnings recovery from 2HFY26 onwards.

* We note that the banking sector’s earnings growth has witnessed successive moderation—from 39.3% in FY23 to 12.8% in FY25. In FY26, we further estimate earnings growth to moderate to ~6.5%, with 1H being more muted.

* We, thus, estimate FY27 earnings growth to recover to ~16.1%. The normalization of credit costs in unsecured segments, continued improvement in the asset mix, and improved treasury performance will enable banks to maintain a healthy RoA trajectory despite macro and rate challenges.

* While the sector may undergo some near-term consolidation due to margin and growth concerns, the gradual recovery in margins and loan growth will enable improved sector performance over the medium term. We prefer banks with superior deposit franchises and prudent risk practices.

* Top ideas: ICICIBC, HDFCB, and SBIN. In mid-sized banks, we prefer FB and AUBANK.

Repo rate: From a shallow cycle chatter to a front-ended 100bp rate cut

* Against the market expectations of a shallow rate cycle just two quarters ago, RBI has implemented a sharp 100bp repo rate cut since Feb’25 and reduced the CRR by 100bp in four tranches starting Sep’25. The sharp pace of rate cuts, supported by controlled inflation and stable trends in currency rates, will help support the consumption and investment cycle in the medium term.

* RBI has changed its policy stance from ‘Accommodative’ to ‘Neutral’, indicating that the scope for further rate cuts now largely depends on the inflation trajectory in FY26 and the broader economic performance. We believe the RBI has front-loaded the rate cuts, and with ongoing geopolitical uncertainty and crude price volatility, the likelihood of further rate cuts appears limited.

* Moreover, we continue to believe that banks will witness NIM contraction in 1HFY26, with recovery expected from 2HFY26, as deposit portfolios reprice and funding costs begin to moderate. Additionally, the benefit from CRR reduction will further boost systemic liquidity and support banking margins.

Earnings moderation to acceleration: Estimate gradual recovery from 2HFY26

* The banking sector’s earnings growth has witnessed successive moderation— from 39.3% in FY23 to 12.8% in FY25. During FY26, we further estimate earnings growth to moderate to ~6.5%, with 1H being more muted at 1.7% earnings growth vs 11.3% growth in 2H earnings.

* While the 100bp rate cut may temporarily pressure NIMs, the benefits from the CRR cut and deposit repricing will mark a likely turning point for earnings recovery.

* We, thus, estimate the earnings growth trajectory to stabilize in 2H and gradually start accelerating thereafter. We project FY27 earnings growth to recover to ~16.1%.

Margin bias negative: Will it be a soft landing vs hard landing ?

* The sharp 100bp reduction in repo rates will adversely impact lending yields for the banking sector, thereby impacting margins. Thus, we expect NIMs to contract over 1HFY26, with banks holding a higher share of EBLR-linked loans being more vulnerable.

* However, the steady improvement in systemic liquidity has enabled banks to reduce deposit rates. We note that several banks had earlier reduced SA rates as the rate cycle turned, and more recently, many have reduced bulk/term deposit rates as well. Moreover, the 100bp CRR reduction effective Sep’25 will further support banking system liquidity and boost margins.

* We, thus, believe that while near-term margins will remain under pressure— with 2Q being more vulnerable than 1Q as the full impact of the rate cut plays out—the gradual moderation in funding costs and the benefits from the CRR cut will begin to support the NIM trajectory from 2HFY26 onwards.

* Additionally, the improving asset mix—driven by a higher share of retail and granular high-yield assets—along with improved systemic liquidity from the CRR cut, which adds INR2.5t of durable liquidity, will help mitigate risks of margin contraction. This supports the case for a soft landing on margins by the end of FY26E.

Asset quality outlook stable; credit cost to stay under control

* FY25 began with notable concerns around asset quality, especially in unsecured retail and MFI segments, where several banks have witnessed higher delinquencies/credit costs.

* However, early-stage delinquencies have started to improve across most lenders, and we expect credit costs in unsecured retail and MFI segments to moderate from 2HFY26 onwards, especially for mid-sized and MFI-focused banks.

* On-ground feedback from lenders, along with RBI’s acknowledgment of asset quality stabilization (post risk-weight normalization in personal loans), indicates easing stress in this segment.

MOFSL view: Continue to follow a stock-specific approach

* Systemic credit growth has decelerated to ~8.9% YoY, driven by slower momentum in retail and secured lending amid elevated CD ratio.

* Against the backdrop of a modest economic growth trajectory (RBI expects GDP to grow at 6.5% in FY26), banks with stronger liability franchises and diversified lending portfolios are better placed to sustain growth and withstand margin pressures.

* While the sector may undergo some near-term consolidation due to margin and growth concerns, the gradual recovery in margins and loan growth will enable improved sector performance over the medium term. We prefer banks with superior deposit franchises and prudent risk practices.

* The normalization of credit costs in unsecured segments, improvement in the asset mix, and improved treasury performance will enable banks to maintain a healthy RoA trajectory despite macro and rate challenges.

* Top ideas: ICICIBC, HDFCB, and SBIN. In mid-sized banks, we prefer FB and AUBANK.

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