Benign asset quality, strong credit growth, but banks are facing these twin near-term challenges

Over the last few years, banks have seen a massive improvement in their asset quality. Recent data for the April-June quarter showed the net non-performing assets (NPA) of all the listed banks, state-owned as well as private, were under 1%.

Net NPAs of 30 scheduled commercial banks have declined to 0.4% as of the June quarter from a peak of around 6% back in financial year 2018, data sourced by Zerodha Capital shows.

Credit growth has also been in double digits, consistently trending ahead of deposit growth in the last several quarters. India Ratings and Research has raised its forecast for the current financial year ending March 2026 and now sees a credit growth of 15%, compared with 13% it had expected earlier.

Deposit growth has consistently lagged credit growth. But that is set to get a boost, although short-term, due to the strong inflows via FCNR (B) deposits, since the Reserve Bank of India opened a special concessionary swap window to shore up foreign exchange reserves. India Ratings has also raised its deposit growth forecast for 2026-27 to 13.6% from 11.4%.

However, banks are facing twin near-term challenges. For one, the loan-to-deposit ratio is expected to stay elevated.

"For the quarter gone by, we were at an almost elevated level of 85 per cent, which is the highest we have seen in so many quarters," pointed Karan Gupta, Head and Director, Financial Institutions, India Ratings.

There are profitability pressures too.

"Pressure on profitability for the sector is likely to emanate from muted NIMs, as well as our expectation of slightly elevated credit costs," added Gupta.

India Ratings expects credit costs for the system to increase 74 basis points in FY27 from 65 basis points in the previous year. For private banks, the credit cost is expected to be 95 bps higher compared with 60 bps for public sector banks.

The outlook for non-banking finance companies is similar, with their expected to be marginal pressure on profits, driven by compression in NIMs and expectations for slightly higher credit costs, Gupta noted.

While the larger NBFCs may have adequate capital buffers, the smaller entities may face pressure in terms of sourcing adequate growth of capital, officials say.

Several initial public offerings planned by mid-sized companies are also getting postponed due to the volatility in the capital market, officials added.

With banks grappling with margin pressure, led by compressed spreads, higher reliance on certificates of deposits and bulk deposits, the overall loan growth is likely to normalise in the second half of the financial year, according to India Ratings.

Since the RBI announced a special concessionary forex swap window in June, banks have seen a surge in flows via FCNR (B) deposits. As of August 22, around $65.4 billion had been raised via FCNR (B) deposits, according to RBI data.

But this surge is also temporary, with officials stating banks' deposit growth should normalise to between 11-13%.

What it could do, though, is lower funding costs, which, coupled with a better asset mix, should help margins begin to normalise, officials added.