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PSU Banks: Resetting to a new normal in profitability

PSBs to sustain 1% RoA; valuations remain inexpensive

* During Jan’23-Feb’24, we published three sector notes on PSU banks (PSBs), arguing that the recovery in RoA to 1% is not a one-off event but more like a homecoming for PSBs. Now, in recent years, PSBs have sustained healthy RoA, and we believe that with margins recovering in 2HFY26 and asset quality remaining stable, they are well poised to deliver steady returns in the coming years.

* In this note, we further explore if PSBs have transformed fundamentally and deserve to be viewed differently given their sustained profitability and growth trajectory.

* PSB sector profitability has reached a record high at INR1.5t and RoA has surpassed 1%. We estimate a 14% CAGR in aggregate earnings of our PSB coverage over FY26- 28E.

* While NIM pressure may weigh on the near-term outlook, rising fee income, a gradual moderation in cost ratios, and healthy coverage levels (PCR ~79%) will help to keep RoA stable at 1.0-1.1%.

* Stronger deposit franchises, conservative CD ratios, and steady traction in Retail, Agri and MSME (RAM) segments have enabled PSBs to regain credit momentum, with PSBs outpacing private banks in FY25 loan growth for the first time in the past 15 years (12% vs. 10%).

* PSBs’ market cap has jumped nearly 5x since FY20, yet they continue to trade at reasonable valuations even as sector RoE remains stable at 18-19% and RoA at ~1%.

* With their strong balance sheets, healthy asset quality, and improving efficiency, we see scope for a gradual but meaningful re-rating for PSBs. Our preferred ideas are SBIN and PNB. Among mid-size names, we prefer INBK given its superior return ratios.

PSBs well poised to sustain RoA at ~1%

Once considered aspirational, PSBs have achieved a structural turnaround, with sector RoA reaching ~1.1% in FY25, supported by improved underwriting, cost control, and robust recoveries. Aggregate PSB profits have surged to INR1.5t in FY25, with their share in banking profits rebounding to 48%. While private banks continue to lead in RoA (1.7-1.8%), top PSBs now deliver comparable or superior RoE (~18), aided by higher leverage. Despite near-term headwinds from margin pressure, modest growth, and ECL implementation down the road, we expect PSBs to sustain RoA at ~1% and deliver ~14% earnings CAGR over FY26-28E.

Healthy liquidity, funding profile to support stable credit growth

PSBs have historically maintained a robust deposit franchise and a comfortable liquidity position, as reflected in their healthy LCR and controlled CD ratio. Despite a gradual erosion in market share, PSBs still command over 62% of system deposits, anchored by their extensive branch presence and strong depositor trust. This has enabled most PSBs to maintain controlled CD ratios, while healthy LCR (130-145% range) further reinforces balance sheet position. This allows PSBs to fund loan growth without aggressively chasing high-cost deposits, giving them a funding advantage across liquidity and rate cycles and ensuring stable 11-12% YoY credit growth.

PSBs’ credit market share to decline at milder pace vs. 200bp annual fall

PSBs have reversed a decade-long trend of market share erosion, regaining ~40bp in FY25 to ~58%. This was supported by healthy credit growth, backed by robust asset quality, strong capital buffers, and ample liquidity that allowed them to sustain steady credit flow, while private peers faced CD ratio constraints. In FY25, PSBs outpaced private banks in loan growth for the first time in 15 years (12% vs. 10%), driven by momentum in retail and MSME segments and relative insulation from stress in unsecured loans. With low-cost deposits, digital investments, and a recovery in consumption demand, we believe PSBs are well placed to deliver 10-12% loan CAGR in FY26E, and unlike the sharp 200bp annual decline over FY11-21, their market share is now expected to decline only marginally over FY26-28E

Navigating NIM pressures with strategic rebalancing; pace of fall to ease

We expect PSBs to face further margin pressure in 2QFY26 due to the repricing of repo-linked loans. However, proactive liability management through the repricing of bulk deposits and certificate of deposits (CDs) at lower rates and replacing high-cost CDs with granular retail deposits will mitigate margin impact. We believe NIMs are likely to broadly stabilize by 3QFY26 and recover thereafter, supporting healthy NII growth over FY27-28E. Alongside, PSBs are cautiously rebalancing their asset mix toward higher-yielding RAM loans. With a low Credit deposit ratio, rising fee income, and prudent use of loan syndication and sell-downs, PSBs are wellpositioned to absorb short-term NIM compression while sustaining healthy credit growth and profitability.

Bond gains provide crucial earnings support; mix in other income rises to 22-40%

Amid the sharp decline in NII, treasury gains have become a key offsetting lever for PSBs, driven by the rally in G-sec bonds following a sharp drop in yields. In 1QFY26, treasury gains accounted for 22-40% of total other income for PSBs, the highest in the past four years, with SBIN, Bank of Baroda (BOB), and CBK reporting the largest contributions of 31-40%. However, treasury gains are expected to moderate in the coming quarters as bond yields remain range-bound, while healthy systemic liquidity and the upcoming CRR cut reduce the need for repeated OMOs.

Cost ratios to improve gradually, thereby supporting RoA

PSBs have traditionally operated with high cost-to-income ratios of 48-55% due to elevated employee expenses (55-66% of total costs), making them less efficient than private peers (~35-45%). However, operating leverage is now improving as revenue growth strengthens, fee income scales up, and headcount remains largely stable. Digital adoption, branch rationalization, workforce optimization, and the government’s PLI scheme are supporting efficiency gains, helping revenue outpace the cost increase. As a result, C/I ratios are expected to gradually decline, narrowing the efficiency gap and supporting stable RoA.

Robust asset quality with best-in-class PCR ratios

PSBs have undergone a remarkable balance sheet transformation, moving from double-digit NPAs to best-in-class asset quality. PCR has risen sharply from 45% in FY18 to ~79% in FY25, while GNPA ratio has declined from 14.6% to 2.8%, bringing net NPA ratio down to 0.5%, comparable with private banks. Slippages have dropped from ~7.9% in FY18 to ~0.7% in FY25 and are expected to stay below 1% through FY27-28E, highlighting the resilience of PSBs’ asset quality vs. private peers (~1.8-1.9% slippages). Credit costs have improved significantly but are expected to rise gradually due to slower recoveries and ECL transition, though the healthy PCR provides a cushion. Contained SMA books, disciplined underwriting and strong governance provide visibility on stable asset quality, while stronger capital positons and cleaner balance sheets make PSBs far more resilient, mitigating the depth of cyclicality in earnings and asset quality compared with past downturns.

Capital adequacy has improved sharply; internal accruals to fund growth

Over the past five years, PSBs have strengthened their CET-1 ratios from 9.4%-11.8% in FY20 to 11.0%-15.3% by 1QFY26, supported by strong internal accruals and capital raises from the market. This capital cushion, combined with robust profitability, improved asset quality, and disciplined underwriting, has enabled steady credit growth while containing risks. Several PSBs like SBIN, Punjab National Bank (PNB), CBK, and Union Bank (UNBK) have successfully tapped equity markets, driving CRAR to a healthy range of 15-18% across our coverage banks. Most PSBs now have a public float of over 25%, though select banks will still need to reduce government holdings to meet minimum promoter shareholding norms.

Valuation and view: RoA outlook steady; should PSBs be looked at from a different lens?

PSBs have seen a strong re-rating over the past five years, shedding their legacy image of lenders with poorer underwriting capabilities to competitive players delivering consistent value to stakeholders. Their aggregate market capitalization has surged by nearly 5x since FY20. Despite healthy RoE of ~18% and sustainable RoA of 1%+, most coverage PSBs trade at reasonable valuations of 0.8-1x forward P/B and 5-7x FY27E EPS. While near-term earnings may face margin pressures, structural improvements in asset quality, capital strength, digital adoption, and operating efficiency offer visibility on sustaining this RoA. PSBs are well positioned to benefit from any capex recovery, though near-term growth will continue to be funded by RAM assets. Stronger capital positions, cleaner balance sheets, and prudent provisioning make PSBs more resilient and limit cyclicality in earnings and asset quality relative to past cycles. Top picks: SBIN and PNB. INBK stands out among mid-sized banks. We remain Neutral on BOB and UNBK.

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