Motilal Oswal prefers private banks over public sector lenders. Here’s why

FY25 has proven to be a difficult year for the banking sector, with the Bank Nifty index delivering a return of 2.6 per cent compared to the Nifty 50’s modest 0.8 per cent gain.

Despite these challenges, several banking stocks have posted double-digit gains, including HDFC Bank (18 per cent), ICICI Bank (16 per cent), Kotak Mahindra Bank (12 per cent), and Federal Bank (18 per cent).

In a recent note, Motilal Oswal Financial Services (MOSL) anticipated that FY26 will begin on a softer note with decelerating earnings in the first half. The brokerage, however, expects banks to witness an earnings recovery. Supported by reasonable valuations, these factors could create attractive investment opportunities throughout the year.

Preference for Private Banks Over PSBs

MOSL highlighted its preference for private sector banks (PVBs) over public sector banks (PSBs), as it believes PSB profitability has peaked, leaving limited room for further re-rating. In contrast, PVBs are better positioned for potential outperformance due to their stronger balance sheets, reasonable valuations, and an improving earnings trajectory from the second half of FY26 onwards.

According to the brokerage, the valuation gap between PVBs and PSBs has narrowed, making PVBs more attractive. The normalization of credit costs in secured lending, coupled with the implementation of Expected Credit Loss (ECL) guidelines, could lead to slightly higher credit costs for PSBs, further pressuring their earnings.

During FY22-25, PSBs delivered a robust 38 per cent earnings CAGR, outpacing the 24 per cent CAGR posted by PVBs. However, MOSL expects this trend to reverse over FY25-27, with PVBs’ earnings growth outstripping that of PSBs, reinforcing its preference for private lenders.

Private Banks: Mixed Performance Amid Growth Challenges

MOSL noted that business momentum remained weak for most private banks in FY25, largely due to elevated credit-deposit (CD) ratios and increased competition for liabilities. Growth in unsecured loans moderated sharply, particularly in the microfinance (MFI), personal loan (PL), and credit card (CC) segments, which exerted pressure on portfolio expansion and overall lending yields.

Several mid-sized private banks, including IndusInd Bank (IIB), RBL Bank (RBK), and AU Small Finance Bank (AUBANK), revised their growth guidance downwards. Larger banks also reported muted growth, weighed down by high CD ratios.

Margins came under pressure as rising funding costs and a decline in the current account savings account (CASA) mix weighed on net interest margins (NIMs). MOSL expects NIMs to remain under pressure in the first half of FY26 due to the declining rate cycle, which will bring down lending yields. However, a mild recovery could occur from the second half of FY26 as funding costs begin to moderate.

Delinquencies in unsecured segments, particularly in MFI and credit cards, remained elevated, leading to higher provisioning for some banks. However, larger private banks with more diversified and secured portfolios were better equipped to navigate the challenging environment.

MOSL forecasts PVBs to report an earnings CAGR of approximately 14 per cent over FY25-27, with growth bottoming out at around 11 per cent in FY26. Its preferred picks in the segment include ICICI Bank, HDFC Bank, Kotak Mahindra Bank (recently upgraded after five years during 3QFY25 results), Federal Bank, and AU Small Finance Bank. Meanwhile, it maintained a neutral stance on Axis Bank (downgraded in January 2024), RBL Bank, IDFC First Bank, and Bandhan Bank.

PSBs: Weak Earnings Outlook Drives Selective Approach

The brokerage turned cautious on PSBs, citing a modest earnings growth outlook. It expects the RoA for PSBs to have largely matured, with earnings growth likely to lag loan growth over FY25-27. The brokerage estimated PSBs' earnings CAGR to moderate to 8 percent over FY25-27, a sharp slowdown from the 38 percent CAGR recorded during FY22-25.

Despite having a high Marginal Cost of Funds-based Lending Rate (MCLR)-linked loan book, it expects PSBs' margins to remain under pressure. This is due to muted loan growth, rising cost of funds (CoF), and the banks’ inability to pass on higher MCLR rates to customers.

While slippages remained largely under control, it highlighted the need to monitor the normalization of slippage run rates and ECL provisioning requirements closely to assess the credit cost outlook.

The PSU banking sector underperformed despite displaying healthy asset quality and earnings stability, as the profitability growth outlook weakened notably compared to prior years. Consequently, MOSL remained selective on the sector, maintaining State Bank of India (SBI) as its preferred pick.

Outlook: Favoring PVBs for Better Growth Visibility

While the BFSI sector experienced headwinds in FY25, MOSL remains optimistic about PVBs in FY26, citing their stronger balance sheets, earnings recovery potential, and reasonable valuations. The brokerage believes that while PSBs may face margin pressures and earnings deceleration, PVBs offer more attractive investment opportunities in the evolving market landscape.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before taking any investment decisions.