Structural gains, valuation support positive for PSU bank stocks

PSU banks have gained 10% in a month as improved profitability, strong deposit franchises, stable asset quality and reasonable valuations drive investor interest

Public sector banks (PSBs) are attracting the attention of investors and the PSU Bank Index has gained nearly 10 per cent in the past month. PSBs have seen return on assets (RoA) climbing to 1 per cent in the financial year 2025 (FY25) and margins are believed to have moved up further in the first half of this financial year (H1FY26) with asset quality remaining stable.

 

In FY25, PSB sector profitability crossed ₹1.5 trillion and PSBs outpaced private banks in credit expansion. The aggregate earnings per share or EPS for PSBs is expected to grow at mid-teens annually between FY26-28. There may be near-term net interest margin or NIM pressure but rising fee income, moderation in cost ratios, and healthy coverage (provision coverage ratio or PCR at 79 per cent) will keep RoA stable at 1.0 per cent or above.

 

Part of the upsurge is driven by strong deposit franchises, conservative credit-deposit ratios, and traction in retail, agri and MSME segments. Even though PSBs have seen market cap rising by over 4x since FY20, valuations look reasonable with return on equity or RoE at 18-19 per cent and RoA at 1 per cent. Further re-rating could be seen if the trends continue.

 

While private banks have better RoA, PSBs are delivering improved RoA and comparable or superior RoE aided by higher leverage. Despite erosion in market share, PSBs still hold over 62 per cent of deposits which translates to comfortable CD ratios, and robust liquidity coverage ratios (130-145 per cent range). PSBs thus hold a funding advantage, ensuring that they can enjoy easy credit expansion if demand grows whereas private banks may see constraints. PSBs may also have reversed or slowed a long-term trend of market share erosion, regaining 40 basis points in FY25, aggregating to about 58 per cent. 

 

The repricing of repo-linked loans will create near-term margin pressure in Q2FY26 but the repricing of bulk deposits and certificate of deposits (CDs) at lower rates and low-cost retail deposits will mitigate margin impact. NIMs should stabilize by Q3FY26 and recover.

 

Treasury gains have become a key profit centre given falling interest rates translating into lower yields for government securities or G-Secs. In Q1FY26, treasury gains accounted for between 22-40 per cent of total other income for PSBs, with SBI, Bank of Baroda (BOB), and Canara Bank reporting contributions of 31-40 per cent. But treasury gains are expected to moderate.

 

PSBs have traditionally suffered from high cost-to-income ratios of 48-55 per cent due to elevated employee expenses (55-66 per cent of total costs), making them less efficient than private banks (35-45 per cent).

 

But, operating leverage is improving as revenue growth strengthens, fee income scales up, and headcount remains stable. Digital adoption, branch rationalisation, workforce optimisation, and PLI schemes are supporting efficiency gains, with revenue gains outpacing costs, cost to income ratios are expected to decline.

 

Most importantly, PSBs have improved balance sheets as they have reduced double-digit non-performing assets or NPAs. The PCR has risen from 45 per cent in FY18 to 79 per cent in FY25, while the gross NPA ratio has declined from 14.6 per cent to 2.8 per cent, with net NPA ratio down to 0.5 per cent.

 

Slippages have dropped from 7.9 per cent in FY18 to 0.7 per cent in FY25 and are expected to stay below 1 per cent. Credit costs have improved alongside. Capital adequacy has improved sharply and PSBs have strengthened their common equity Tier-1 ratios from the range of 9.4 per cent-11.8 per cent in FY20 to 11.0 per cent-15.3 per cent by Q1FY26.

 

PSBs like SBI, Punjab National Bank (PNB), Canara Bank and Union Bank have successfully tapped equity markets, pushing capital to risk-weighted assets ratio to a healthy range of 15-18 per cent. Most PSBs now have a public float of over 25 per cent, though select banks still need to reduce government holdings.

 

Despite re-ratings and strong capital gains, PSBs still trade at reasonable valuations and their structural improvements and good medium-term growth prospects could lead to further re-ratings.