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Headwinds receding; improved operating performance to support a gradual recovery

* FY26 earnings for banks under our coverage grew in low single digits, reflective of NIM pressure in a declining repo rate environment. Over the last five years, PSBs expanded at a 38% PAT CAGR vs 20% for private banks, driving a meaningful de-rating of private bank valuations, while insurers, PSBs, and capital market companies re-rated.

* Deposit mobilization has remained a key industry-wide challenge, with system deposit growth (12.7% YoY) continuing to trail credit growth (17.7% YoY), leading to elevated C/D ratios (~83%) and a sharp decline in the CASA mix. While RBI's FCNR(B) measures are expected to provide a liquidity boost, deposit mobilization is likely to remain a more structural challenge in the banking sector.

* Unsecured credit growth moderated sharply since FY24 owing to overleveraging and tighter RBI regulations, while wholesale credit has rebounded in recent months, led by higher working capital demand. This shift in the mix is weighing on banks’ NIMs, with bank management indicating continued NIM pressure over the medium term.

* The recent easing cycle highlights the asymmetry in transmission, with a 125bp repo cut translating into only a 52bp decline in outstanding WADTDR, vs a 90bp dip in WALR, reflecting intense competition for TDs. In comparison, the earlier 250bp tightening cycle saw WADTDR and WALR increase by 206bp and 115bp, respectively, underscoring the growing share of EBLR-linked loans and lower unsecured lending.

* Given the uncertain global macro environment, EM banks have witnessed a significant de-rating (~10-30% lower P/B valuations) over the last five years, while developing market banks have witnessed a re-rating over the same period.

* We expect a recovery in deposit mobilization in 2HFY27, aided by FCNR(B) flows. The banking sector’s earnings are likely to rebound with ~16% CAGR over FY26-28, fueled by private banks, which are expected to deliver an earnings CAGR of ~21%, outperforming PSU banks’ expected ~10% earnings CAGR. Our top ideas are ICICIBC, HDFCB, SBIN, AUBANK, and RBK.

Earnings growth slows sharply to single digits

FY26 witnessed a 3% YoY growth for banks under our coverage, reflecting the impact of a declining interest rate environment. Over the past five years, PSBs under our coverage universe delivered a PAT CAGR of 38%, compared with 20% for private banks. Private banks posted the weakest earnings growth across the BFSI space in the post-COVID period, leading to a meaningful de-rating in valuations. In contrast, insurance companies, PSBs, and capital market players witnessed valuation rerating, supported by stronger earnings performance and an improving growth outlook. Going forward, we estimate an FY26-FY28 earnings CAGR of 21% for private banks and NBFCs under our coverage, while PSBs are likely to deliver a moderate PAT CAGR of 10%.

Macro uncertain; ECL transition to increase provisioning burden

* The uncertain global macro environment, marked by the West Asia conflict, trade disruptions, volatile commodity prices, and divergent monetary policies, has weighed on the operating environment for Indian banks. While domestic economic fundamentals remain resilient, global uncertainty has led to cautious corporate capex, increased volatility in capital flows and currency movements,and weaker investor sentiments. The recent RBI relief measures on FCNR(B) deposits and overseas borrowings is expected to provide temporary relief, with foreign flows of USD80-100b expected in the near term. However, we remain watchful of the global macro environment.

* Transitioning to ECL norms is likely to weigh on the banking sector through a onetime transition impact and higher steady-state credit costs, driven by increased Stage 1 and Stage 2 provisioning requirements. PSBs are expected to face a greater impact, given their lower provisioning buffers and historically higher slippage rates.

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