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SMID private sector banks are at an inflection point. They are in a better position to capitalize on accelerating banking, given smaller bases and greater risk appetites. The turn in the credit cycle also benefits them, leading to strong FY27E earnings acceleration. The wave of strategic transactions further strengthens the investment case, as it solves capital woes and strengthens deposit franchises. We are positive on the entire basket—Federal, RBL, IDFC First, and Yes—and add IDFCFB to our model portfolio.

Riding the growth recovery: We forecast credit growth to accelerate to 11% in FY26E and 13.3% in FY27E, based on RBI’s easing and improved consumer demand (link to detailed note on credit cycle). Retail remains the key driver and we build in 15%/17% growth for FY26E/FY27E, with autos and unsecured loans being the outperformers. The wholesale segment’s growth should stay stable at 7-8%, with improved demand offset by disintermediation and risk aversion. Moreover, the RBI’s benign liquidity policy should enable faster deposit growth, which feeds into the loan growth cycle. SMID banks are in a better position to exploit this growth trajectory, given that they have low bases, greater exposure to higher-risk categories, and benefit more from an easier liquidity environment.

Turnaround in profitability: Most banks reported a sequential drop in credit costs in Q2FY26, with slippages and NPLs also starting to fall, barring one-off hits to a few. The management commentary also indicated that asset quality is peaking, both in retail and the highly stressed MFI segments. We expect credit costs to fall by 4-22bps in FY27E across our banking universe, driving improved ROAs. Margins are also expected to stabilize, with the hit from repo rate cuts being front-ended in FY26E itself. The SMID banks are generally more cyclical and should deliver 110-30bps ROA delta for FY27E vs (10)-30bps for the larger banks.

A wave of strategic acquisitions: There has been a wave of strategic acquisitions in the lending segment, with Blackstone-Federal, Emirates-NBD-RBL, SMBC-Yes Bank, Abu Dhabi IHC-Samman, and Warburg Pincus-IDFC First being announced in the last 3M. This is a big positive for smaller lenders as it solves their main impediments to scalability: i) access to capital; ii) market stature, which helps lower cost of deposits/borrowings; iii) access to world-class systems/processes/governance structures. Going forward, we expect this cohort to gain market share at the expense of larger banks (and PSUs).

Adding IDFCFB to the model portfolio: We have space for only one from this cohort in the EMP and add IDFCFB for its optimal mix of a strong deposit base, strong retail product mix, best-in-class technology, and valuations at 1.34x Sep27E P/BV. Past execution has been disappointing, but we think the stars are aligning for the bank after the Warburg capital injection. This is a relative call; we like the cohort of Federal, RBL, Yes, and IDFCFB.

SFB/MFI – saturated sector: SFB/MFIs have similar tailwinds in the short term, but we see long-term challenges. The MFI sector, in our view, is overpenetrated with +60% of the addressable households already accessed. Going forward, growth will either be muted or the deep cyclicality of overleverage and credit shocks will continue. SFBs transitioning to universal banks will also face multiple challenges in scaling up – we think pain will come before the upsides materialize. We prefer to stick to the universal banks.

PSU Banks – challenging FY27E: PSU banks are set for a strong H2FY26E, but the momentum is set to fizzle out in FY27E. Loan growth is set to accelerate with the overall market momentum, but with limited deltas. On the other hand, the drop-off in treasury income and high opex growth due to a new wage agreement would drive lower ROAs and ROEs for most PSU banks. The relatively attractive valuations lack a long-term rerating trigger, and we see no case for a long-term investment thesis. Even the short-term H2FY26E trade is at risk if long bond yields spike, which is a real possibility if tax collections undershoot

Other EMP changes – add Gravita and KJC: We make the following swaps: i) Bikaji for Gravita, as the new capacity commissioning is imminent. This is a high-growth stock (GFA up 4x over FY25-28E) in a sunrise sector, with a strong track record in execution. ii) Voltas for Kajaria, given strong cost-led margin improvement and a possible demand recovery in H2FY26E; iii) ICICI for BAF, as the latter is more geared to capture H2FY26 growth. iv) Kfin for IDFCFB.

Add – Gravita, Kajaria Ceramics, IDFC First Bank, and Bajaj Finance.

Exit – ICICI, Kfin Technologies, Voltas, and Bikaji.

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