India's banking sector is poised for a significant earnings recovery following a subdued FY26. With profit growth rebounding, the sector is benefiting from stabilizing margin pressures and normalizing credit costs, setting the stage for a more constructive earnings phase.
Sector earnings growth, which decelerated to 6.6% in FY26, is expected to recover substantially over the next two years. This recovery is underpinned by steady loan growth, resilient operating profitability, and improving asset quality trends, particularly in previously stressed unsecured retail portfolios. Private lenders are anticipated to spearhead this growth, leveraging stable net interest margins (NIMs), healthier provision buffers, and favorable trends in mid-market retail and unsecured lending.
Conversely, public sector banks are entering a phase of earnings moderation as their structural liquidity advantages diminish and deposit mobilization becomes increasingly competitive. The intensifying competition for deposits is emerging as a critical near-term challenge, with banks compelled to offer higher interest rates, thereby increasing the cost of funds and potentially constraining margin expansion.
The introduction of the expected credit loss (ECL) framework is another pivotal transition, likely leading to a normalization in reported credit costs. While the sector appears well-capitalized to absorb this shift, it introduces an additional variable into earnings visibility, especially for lenders with thinner provision buffers. Asset quality risks, however, seem more manageable than in previous quarters, with stress in unsecured segments showing signs of easing.
ICICI Bank remains a top pick with a target of Rs 1750, supported by its strong retail and corporate franchise, stable margins, and disciplined risk management. In 4QFY26, ICICI Bank's PAT was INR137b, reflecting an 8.5% YoY increase, driven by negligible provisions and steady core income. AU Small Finance Bank, with a target of Rs 1275, also presents a highly constructive outlook, supported by industry-leading growth and improving asset quality trends. Its PAT rose 65% YoY to INR8.3b in 4QFY26, driven by strong NII growth and sharply lower provisions.
Background
The Indian banking sector has been navigating a challenging environment characterized by margin pressures and elevated credit costs. However, the current stabilization in these areas marks a shift towards a more favorable earnings trajectory. This transition is crucial as it reflects the sector's ability to adapt and thrive amidst changing economic conditions.
The medium-term investment case for the banking sector is anchored in earnings normalization rather than balance-sheet repair. With net interest income expected to remain the principal growth engine and profitability metrics improving from FY27 onward, the sector is transitioning from a defensive recovery story to a more differentiated growth narrative. Investors should closely monitor private lenders with stable deposit franchises and margin resilience as they are best positioned for this next phase of growth.
