Motilal Oswal sector of the week: Top bank stocks to buy amid PSL push

Motilal Oswal Financial Services explains how priority sector lending is shifting from regulatory burden to earnings lever for banks and highlights HDFC Bank and Indian Bank as top stock picks

Motilal Oswal Financial Services outlook on Banking sector

  Priority Sector Lending: From regulatory burden to earnings lever

 

The priority sector lending (PSL) landscape is undergoing a quiet but meaningful transformation, with banks increasingly treating compliance as a balance-sheet and earnings optimization tool rather than a regulatory box-ticking exercise. Recent trends highlight a clear divergence between private sector banks and public sector banks (PSBs) in both strategy and outcomes.

 

Large private banks have expanded their PSL portfolios at a faster pace than overall loan growth over the past few years, deliberately deepening on-balance-sheet PSL assets. This approach has reduced their dependence on priority sector lending certificates (PSLCs) and low-yielding Rural Infrastructure Development Fund (RIDF) deposits. In contrast, PSL growth for PSBs has lagged overall credit expansion, with several banks relying heavily on PSLC purchases to bridge shortfalls. Asset quality trends are mixed: PSBs have reported steady improvement in PSL GNPA and NNPA ratios, supported by tighter underwriting and recoveries, while private banks have seen uneven trends, partly due to stress in microfinance-linked exposures.

 

The combined PSL loan book has grown at a healthy pace in recent years, driven by expansion in agriculture, MSME, services and retail-linked segments. Private banks have built a more diversified PSL mix, while PSBs continue to carry agri-heavy portfolios. A key challenge remains sub-target compliance, which forces some banks to incur recurring PSLC expenses or park funds in RIDF deposits with long tenors and sub-market yields, compressing margins. At the same time, surplus lenders have been able to monetise excess PSL through PSLC sales, generating meaningful fee income and partially offsetting pressure from tighter margins and fee income elsewhere.

 

PSLCs have evolved into a flexible instrument for both compliance and income management. Banks with structurally strong PSL origination are emerging as consistent net sellers, while deficit banks remain buyers, creating a clear “haves versus have-nots” dynamic. There is also a visible shift away from unsecured, volatile PSL segments towards more secured retail and granular MSME exposures, reflecting a sharper focus on risk-adjusted returns rather than headline compliance alone.

 

In a challenging operating environment marked by margin pressure and competitive intensity, efficient PSL management has become a material differentiator. Banks that embed PSL origination into their core lending strategy can avoid recurring regulatory leakages via PSLC purchases or RIDF deposits, while unlocking incremental income streams and improving balance-sheet efficiency. Over the medium term, institutions with a diversified PSL mix, disciplined underwriting and lower reliance on external compliance mechanisms are better positioned to deliver more stable profitability and asset quality, underscoring the shift in PSL from obligation to opportunity.

 

Top Bank Stocks to Buy in India

HDFC Bank: Share price target: ₹1,175

HDFC Bank shares continue to benefit from its dominant retail banking franchise, granular deposit base, and disciplined risk management. Management expects loan growth to outpace system levels in FY27, aided by calibrated branch additions, operating leverage improvement, and a gradual normalization of the CD ratio. Q3FY26 profit grew 11 per cent Y-o-Y to ₹18,650 crore, in line, as lower provisions offset the ₹800 crore labor code impact. NII rose 6.4 per cent Y-o-Y, NIMs expanded 8bp QoQ to 3.35 per cent, while asset quality remained stable with GNPA/NNPA at 1.24 per cent/0.42 per cent. We project FY27E RoA/RoE of 1.9 per cent/14.5 per cent, supported by deposit repricing, better operating leverage, and strong provision buffers. With improving growth visibility and stable asset quality, we are positive on HDFC Bank.

Indian Bank: Share price target: ₹1,025

Indian bank continues to benefit from a diversified loan mix across retail, MSME and corporate segments, strong risk management, and best-in-class provisioning. Management’s proactive stance on SMA provisioning and early ECL preparedness strengthens balance sheet resilience and supports sustainable profitability through cycles. 3QFY26 performance was supported by healthy loan growth of ~15 per cent Y-o-Y, stable deposit traction, and a 5bp QoQ improvement in NIMs to 3.28 per cent. Slippages moderated sequentially, while GNPA/NNPA declined to 2.23 per cent/0.15 per cent, reinforcing asset quality comfort. Management highlighted a strong corporate credit pipeline and expects credit costs to remain contained despite some MCLR repricing impact. We raise FY27/FY28 earnings estimates and expect FY27 RoA/RoE of ~1.4 per cent/17.8 per cent, supporting our positive view.  ===================  Disclaimer: This article is by Motilal Oswal Financial Services Research Desk. Views expressed are their own.