MUMBAI: Flagging a slew of challenges in the near-to medium-term, a domestic rating agency has retained its neutral outlook on the banking sector for the rest of the current fiscal.
The challenges cited includes falling credit demand, pressured margins as almost all loans are getting priced to the external benchmark lending rates (EBLR) and over 60% of existing loans get repriced lower and elevated loan-deposit ratio (LDR) highlighting the continued dependence on deposit franchises.
The banking system LDR at 80.3% for FY25, while is on the decline, remains still elevated and gaining incremental deposit market share remains a key monitorable, considering banks want to target higher loan growth in the second half of the fiscal, noted India Ratings.
More importantly, the 100 bps repo rate cut and the system having a high share of EBLR linked loans at 61.6% in FY25 (private banks at 86.7% and public sector banks at 45.9%), margins are likely to be under pressure in the near-term, the agency adding however, from the second half onwards margins will recover as deposit rate cuts will ease the pressure partially.
We maintain our neutral sectoral outlook and a stable rating outlook for banks. Near-to medium-term challenges include an elevated LDR; margin compression given a higher share of EBLR based loans; and a moderation in loan growth dynamics. Profitability while being healthy is expected to moderate in FY26 with rising slippages and higher credit costs over FY25 levels, says Karan Gupta, head financial institutions at the agency said Tuesday.
Credit growth fell to 9.8% by July 11 from 14% a year ago, mainly due to cautious lending in the retail segment, slowdown in lending to the non-bank companies and the capital markets offering lower rates. Tight liquidity conditions in FY25 along with muted spreads led to banks slowing down lending to corporates where private capex was already slow and deleveraging was on.
However, services and retail loans have now become the prime drivers of loan growth, with an incremental contribution of 30.3% and 44.7% in May compared to 33.7% and 36.7% in March, respectively.
The agency continues to expect credit growth of 13% for FY26, with a revival in lending to NBFCs and retail sector, in addition to the lower yield curve supporting corporate disbursements.
Describing deposit accretion a structural concern, He says since FY22, deposit growth has consistently lagged credit growth by an average of about 380 bps, pushing LDR to 80.3% in FY25 from 70% in FY21. Systemic efficiency, active liquidity management and emerging investment products that offer higher returns and replace the stability offered by fixed deposits, are likely to persist in the medium term.
The narrowing gap between loan and deposit growth is evident from the moderation in incremental LDR to 29% and 77% as of July 11 from 54% and 96% a year ago, respectively.
Ruling out largest concerns on the asset quality side, as the stress is mostly limited to unsecured retail credit only, the report says at the system level asset quality has improved to a decadal low in FY25, with gross non-performing assets falling to 2.3% and net non-performing assets at 0.5%.
However, stress in unsecured retail credit, especially among private sector banks remains evident, particularly in personal loans, credit cards, and microfinance.
The November 2023 RBI advisory also led to a slowdown in unsecured retail loan growth to 11.6% now from 27% during September 2021-September 2023, though this segment still as of May 2025 accounts for 32.3% of the total retail loans and 11.3% of total advances, with GNPA rising to 1.8% in FY25 from 1.6% in FY23 and FY24.
Though, secured retail segments such as mortgages (50.1% of retail) and vehicle finance (10.5% of retail) remains stable, with the system-wide stress data for unsecured retail has been steady in the 7-8% range over FY23-FY25.
Pencilling in for a slight moderation in profitability, the agency expects net interest margins to moderate in FY26, due to the lag in deposit repricing following the 100 bps repo rate cut, especially as 62% of the banking system loans are EBLR-linked now.
The agency believes the adjustment will largely occur by the end of the second quarter, considering the strength of the liability franchise, the rationalisation on term deposit rates and the savings rate cut across buckets. For private sector banks, with as much as 86.7% of loans are tied to EBLR, will likely see a sharper NIM impact than their state-run peers who have only 45.9% of loans priced to EBLR.
The agency’s optimism comes from two factors: The RBI’s shift in policy stance and liquidity infusions of Rs 5.6 trillion (2% of system assets) have supported surplus liquidity in the system (surplus tops Rs 4 trillion now), while a gradual 100 bps CRR cut to 3% starting September will inject another Rs 2.5 trillion, aiding NIM recovery.
However, despite elevated operating costs from technology investments, credit costs are expected to stay below 1%, with RoA moderating slightly to 1.33% from 1.38% in FY25.