Banking revival in 2025: Why strong liability franchises stand to gain

In fact, investor sentiment turned bullish on Wednesday ahead of the Reserve Bank of India’s (RBI) monetary policy meeting on Friday, with speculation around a possible reduction in the cash reserve ratio (CRR). The Nifty Bank index climbed over 1%, led by a 2.1% jump in HDFC Bank shares to ₹1,865 apiece.

However, market experts caution that only banks with robust liability franchises and superior credit extension capabilities are poised to take full advantage of the upcoming credit cycle.

“Earlier, all the banks were looking the same because growth was coming off a low base with a moderating credit growth and capex (capital expenditure) cycle. Moving ahead, one will need to have a strong liability franchise for them to make most of the upcoming credit cycle," Trideep Bhattacharya, president and CIO of equities at Edelweiss Mutual Fund told Mint.

Read this | PSU banks are giving the best FD rates in eight years. Here's why

Strong liability franchises refer to a bank’s ability to attract and sustain a stable, cost-efficient deposit base, which is essential for funding lending activities. The quality, scale, and stability of these liabilities (primarily deposits) directly influence a bank’s profitability and resilience, making them critical in navigating competitive credit cycles.

The credit and deposit squeeze

Systemic credit growth, adjusted for the HDFC merger, slowed to 12.4% year-on-year as of 15 November, compared to 12.8% in October and 14.4% in September, according to data from the Reserve Bank of India.

Credit growth slowed across segments, with systemic retail loan growth easing to 15.8% year-on-year in October 2024, down from 16.4% in September. The moderation was driven by a notable decline in auto and unsecured retail loans, even as housing loan growth remained stable.

This moderation affected all banks, as credit growth slowed across the board. Contributing factors included reduced government spending ahead of elections, erratic monsoons, and extreme heatwave conditions. Meanwhile, deposit growth aligned with credit growth, rising by 11.6% year-on-year, leading to tighter margins across the banking sector.

Read this | Private lenders see stress in credit cards, personal loans in Q2

Elevated deposit costs and sluggish base growth weighed heavily on net interest margins (NIMs) for both public and private banks. In the September quarter, net interest income (NII) grew just 1% sequentially, according to Sharekhan by BNP Paribas.

“In fact, profitability will remain lacklustre moving forward, especially for private banks, as their cost of credit will continue to rise in Q3, particularly in the unsecured, retail loans segment," Mohit Khanna, fund manager at Purnartha PMS told Mint. “The BFSI sector is bouncing along the bottom right now. But we should see a recovery in FY26 onwards."

Public vs private banks

Credit costs for private banks increased by 10 basis points sequentially, with IndusInd Bank, IDFC First Bank, and AU Small Finance Bank seeing the sharpest rises, according to an ICICI Securities report dated 27 November. A higher cost of credit reflects souring asset quality and higher provisioning for non-performing assets (NPAs), which depletes a bank’s capital available for credit extensions.

Private sector banks, on a retail lending spree to boost credit growth, have faced rising delinquencies among low-income borrowers, credit card holders, and personal-loan users. As a result, net NPA levels for private banks stood between 0.2% and 1.5% in Q2, compared to 0.2% to 0.98% for public sector banks (PSBs).

“Stress rise in MFI (micro finance institution) segment was higher than expected with a sharper rise in the 30 days-past-due bucket across lenders, suggesting that slippages in MFI are yet to peak," the ICICI Securities report said. “(However, sequential rise in) overall slippages were broadly stable at 1% for PSU banks and 1.7% for private banks."

Read this | MFI stress may weigh on small finance banks’ loan growth, asset quality in short term

Public sector banks fared better, benefiting from lower slippages, improved recoveries from technically written-off accounts, and higher gains in treasury income. These factors contributed to a 33% on-year growth in the operating profits of major PSBs in Q2, compared to a modest 13% on-year growth for private banks, according to Sharekhan.

Relatively cheaper valuations and more room for growth further explain why the Nifty PSU Bank index has surged 24% in 2024 so far, significantly outperforming the Nifty Private Bank index, which has gained just 4%. By comparison, the benchmark Nifty 50 index has delivered a 13% return during the same period.

Challenges and path to recovery

Big private names like HDFC Bank have felt the sting of foreign institutional investor (FII) selling, exacerbated by global risk aversion and higher US bond yields. This trend is expected to moderate by the end of December.

As of 14 November, FIIs have net sold ₹1.16 trillion worth of domestic shares in 2024, with the financial services sector bearing the brunt of the outflows at ₹70,963 crore.

Read this | October surprise: An influx of retail investors hasn’t made FIIs irrelevant

Once celebrated for its 20% compound annual earnings growth, HDFC Bank has struggled since its merger with the erstwhile HDFC two years ago. Post-merger, its loan-to-deposit ratio has consistently remained above 100%, forcing the bank to offload loans from its balance sheet through securitization.

Looking ahead, favourable state election outcomes and a near two-year low GDP growth of 5.4% in Q2—well below the consensus estimate of 6.5%—have set the stage for aggressive government spending and monetary easing by the RBI.

These easing measures are expected to lower deposit costs and initiate a second round of credit off-take in the economy, eventually improving banks’ net interest margins and profitability.

While no major negative earnings surprises are anticipated in Q3, market experts believe a significant catalyst for re-rating will only emerge once the RBI begins cutting interest rates, possibly in 2025.

“We now expect a rate cut in India in February 2025 vs December 2024 previously. Ceteris paribus (Latin for all things being equal), this leans out our FY26 margins and earnings expectations and slightly improves FY25 estimated earnings," a BNP Paribas Exane report noted on 19 November.

Since the BFSI sector accounts for 37% of the benchmark Nifty 50 index, a meaningful rally in big names like HDFC Bank, Kotak Mahindra Bank, and Axis Bank could lift broader index returns. Fund managers, however, are being selective, reducing underweight positions only in banks with stronger liability franchises or a larger credit extension base.

“We prefer to be positioned in stocks with stronger underwriting capabilities and a lower exposure to segments where credit cost is likely to go up (especially unsecured retail and microfinance)," a Nomura Global Markets Research report from 2 December said. “We also have a preference for banks that have lower deposit-led growth pressures."