FY26 likely to bring slight recovery in banks' earnings growth momentum

The banking sector and more broadly, financials, have outperformed the Nifty50 in FY25 in terms of index returns. The Nifty50 is up 5.3 per cent, while the Bank Nifty has gained 9.4 per cent and the Nifty Financials rose 19.5 per cent. Some private banks like HDFC Bank (26 per cent), ICICI Bank (23 per cent), Kotak Mahindra Bank or KMB (21 per cent), and Federal Bank (28 per cent) have done very well.

 

However, earnings growth has been trending down, with credit growth decelerating to 11 per cent year-on-year (Y-o-Y), versus an average credit growth of 16 per cent in FY24. Public sector (PSU) banks underperformed, and the PSU Bank index dropped by 10.62 per cent in FY25.

 

FY26 may see a modest recovery in earnings growth after a period of bottoming out. The reversal in the repo rate cycle and limited room for banks to cut deposit rates will keep margins under pressure. Higher slippages and asset quality stress with exposure to unsecured retail may push provisioning up, especially for banks with higher exposures in these segments.

 

FY26 may see earnings growth down to 8-9 per cent (for private and PSU banks combined) before recovering to historic rates of 14.5 per cent earnings growth in FY27 or beyond. On the plus side, reduction in the repo rate translates into positive net interest margin or NIM outlook for NBFCs (such as vehicle financiers), and could result in better credit offtake for banks as well.

 

High credit-deposit or CD ratios imply competition for deposits, tight margins and constraints on credit growth. Several banks, including IndusInd Bank, RBL Bank, and AU Small Finance Bank, have revised growth guidance downwards, and larger banks may report muted growth due to high CD ratios.

 

NIMs are likely to remain under pressure in H1FY26 as this stage of the rate-cycle reversal reduces lending yields. A recovery could start from H2FY26 onwards as funding costs moderate.

 

Delinquencies in microfinance institutions or MFIs and credit cards are high, though slippages have remained under control for most banks. This is leading to increased provisioning. PSU banks may see earnings growth lagging loan growth over FY25-27 and earnings growth may drop to mid-single-digits. Small Finance Banks (SFBs) faced serious challenges due to greater exposure to MFI and retail.

 

The valuation gap between private banks and PSUs has narrowed, making private banks more attractive. During FY22-25, PSU banks saw 38 per cent earnings growth, far better than the 24 per cent earnings growth for private banks. However, this trend is likely to reverse over FY25-27 with private banks outrunning PSUs comfortably in terms of earnings growth.

 

NBFCs face challenges, like deteriorating asset quality due to customer overleveraging (MFI segment), macroeconomic factors, and weak demand for commercial vehicles or CVs. Some signs of recovery are visible in MFI, with improved collection efficiency. But the impact of new guard rails for MFIs will take time to be assessed. This has implications for banks with exposures to these areas, including being lenders to NBFCs.

 

Large cap banks with diversified asset portfolios seem the safest bets, as valuations seem reasonable. Among these, private banks are better-placed to deliver growth and possess better balance sheets. KMB has seen a big run up in share price since Q3FY25 while investors have been slightly hesitant on HDFC Bank, given the merger. ICICI Bank has the best return on equity or RoE of around 17 per cent. Axis Bank has low capital adequacy ratio and high credit deposit ratios but it has invested in rural/semi-rural penetration which could help in terms of superior yield in retail credit. Among PSU banks, SBI has leadership in many retail segments but lower adequacy could force it to raise capital soon, which may push RoE down.