PSU banks may underperform in near term amid Iran war and macro risks

The Iran conflict, rising crude prices and currency pressure may weigh on banking stocks, with PSU banks likely to face sharper downside risks than private peers in the near term

The ongoing conflict in West Asia has already led to several macroeconomic challenges. Growth may slow due to energy shock. Currency pressure increases as import bills spike and the selling of foreign portfolio investments (FPIs) accelerates. Further, the Maharashtra government is going through with its promise of farm-loan waivers. Taken together, these present substantial challenges for the Reserve Bank of India (RBI) ahead of its April monetary policy update. 

  The central bank must tread a narrow path to ensure liquidity to sustain growth, while ensuring inflation doesn’t spiral up and the rupee doesn’t experience too much volatility. Banks have cleaned up balance sheets with writeoffs. Most banks have low gross net performing assets (GNPAs) and strong common equity tier-1 (CET-1) . January and February saw strong credit growth but the war in Iran has weighed on this narrative. 

System credit growth was at 14.4 per cent year-on-year (Y-o-Y) for January with momentum in retail and services, despite agriculture and industry growth moderating. The systemic loan-deposit ratio (LDR) was high at 82.5 per cent. Growth was led by loans to non-banking financial companies (NBFCs) and unsecured retail contributing 26 per cent and 25 per cent, respectively. In retail, loans were led by vehicle, housing, gold loans while micro, small and medium enterprises (MSMEs) loan growth was up 28.5 per cent Y-o-Y. Large corporate loans growth rate declined month-on-month (M-o-M) in January to 5.5 per cent, compared to 8 per cent in December. System liquidity was in surplus in January and February. The benchmark 10-year government security (G-sec) yield hardened 3 basis points (bps) M-o-M to 6.69 per cent in February.

 

The weighted average lending rate (WALR) on fresh loans increased 44 bps M-o-M for public-sector banks (PSBs) and 18 bps M-o-M for private banks while weighted average domestic term deposit rates (WATDR) on fresh term deposits increased by 6 bps for PSBs and decreased by 2 bps for private banks.

 

In February, the RBI kept repo rates unchanged at the Monetary Policy Committee (MPC). Most analysts expect it may continue with a wait-and-watch policy in April. The RBI will also weigh the information coming out of the US Federal Reserve’s FOMC meeting next week.

 

The RBI has indicated that in addition to the LDR, the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) are now key measures of bank liquidity. LCR and NSFR look at all liabilities (including equity) and this indicates that higher LDR can be maintained while extending credit, enabling an incremental 7 per cent credit expansion and pushing LDR to around 89 per cent if deposits remain constant.

 

PSBs have reported relatively lower cuts in marginal cost of fund-based lending rates (MCLR). One-year MCLR for private banks dipped 30-275 bps while PSBs’ MCLR rate saw declines at 30-40 bps. All banks have repriced term deposits down to some extent, which implies better net interest margins (NIMs).

 

Households dominate deposits at 60 per cent, growing 10 per cent Y-o-Y in the third quarter of 2025-26 (Q3FY26), while growth in government deposits was slower. PSBs have 70 per cent of their deposits from households while the same figure for private banks is at 55 per cent.  

 

Where credit growth is concerned, urban markets have grown slower compared to rural. Private banks have 85 per cent of deposits from urban areas while PSBs get 70 per cent of their deposits from urban regions. CASA deposits grew 9 per cent Y-o-Y while term deposits grew 10 per cent Y-o-Y.

 

Despite the shock following the West Asia conflict, there are growth options if retail demand is stable and the pickup in MSME and corporate demand continues. Assuming the RBI does not cut liquidity and the war does not continue indefinitely, growth momentum may continue, even if it is at a lower pace.

 

Bank earnings growth could outpace loan compound annual growth rate (CAGR), given stable or improving NIMs, easing deposit costs, and a neutral or accommodative RBI stance. The Q3FY26 saw robust NIMs and good bank returns. Competitive intensity across banks remains high.

 

But the Iran conflict is a black swan, which may make the ‘business as usual’ estimates go awry. The historical performance of PSBs is relatively weaker than private banks during shocks, partly due to higher treasury contributions to PSB earnings. PSBs are also more exposed to farm loan waivers and other potential moratoriums.

 

Since the start of the war, PSBs have fallen by 11 per cent, compared to a 7 per cent fall for private banks. In the near-term, PSBs may see steeper downsides until resolution of the West Asia conflict. But they may also see fast recoveries once the crisis is over.