Whalesbook
The Deepening Margin Squeeze
The current phase of monetary easing by the Reserve Bank of India (RBI) has triggered a more profound contraction in net interest margins (NIMs) for Indian banks than observed during the rate cuts preceding the COVID-19 pandemic. Analysis of financial data from Q4 FY20 through Q3 FY26 reveals that top lenders have experienced an average NIM shrinkage of 154 basis points (bps), a stark contrast to the 40 bps average reduction seen approximately six years ago [cite: Source A]. This disparity highlights not just the depth of rate cuts but also underlying structural changes within the banking sector's funding and pricing mechanisms.
The Structural Shift in Deposit Competition
Analysts identify a fundamental challenge in the current environment: an intensifying competition for deposits. This has led to a significant rise in the cost of funds, with average deposit costs for scheduled commercial banks exceeding 5% in 2025, up from 4.7% in 2024 [cite: Source A]. This upward pressure on liability costs is occurring even as lending rates, particularly those linked to the External Benchmark Lending Rate (EBLR), are compelled to decline following RBI policy rate reductions. The RBI's aggressive rate cuts, totaling 125 bps between February and December 2025, have outpaced the ability of banks to pass on lower costs to depositors, creating a profitability squeeze. This dynamic is exacerbated by a long-term trend of declining household reliance on fixed deposits, which has fallen to 35% of household capital in FY25 from 58% in FY12, as savers seek higher yields elsewhere [cite: Source A]. Consequently, banks are increasingly substituting low-cost Current Account Savings Account (CASA) deposits with more expensive bulk deposits and Certificates of Deposit (CDs) to manage funding needs, further straining margins.
Public vs. Private Sector Dynamics
The margin compression is not uniform. While all four major public sector banks analyzed saw greater margin erosion in the current cycle, State Bank of India and Bank of Baroda had even registered margin increases during the initial COVID-era rate cuts. Among private banks, Kotak Mahindra Bank's margin declined by 43 bps in the current cycle compared to 20 bps in 2020, and Axis Bank faced a 33 bps reduction after nil shrinkage previously. HDFC Bank has presented an outlier, with its NIM contracting by only 11 bps in the current cycle against 20 bps in the earlier one, though its margins have remained volatile around 3% post-merger [cite: Source A]. Recent reports suggest public sector banks saw sequential NIM improvement in Q3 FY25 (September quarter), while private banks continued to experience declines, indicating varying degrees of resilience and cost management. For instance, SBI's full-bank NIM was around 2.97% in Q2 FY26, while Bank of Baroda's was 2.96%, and PNB's was 2.72%. In contrast, private players like Axis Bank reported 3.73% and Kotak Mahindra Bank 4.54% in the same period, though these also represented sequential declines for Kotak.
Valuation and Outlook
The sector is currently trading at a mixed valuation. As of February 2026, P/E ratios for the major banks range from as low as 7.38x for Union Bank of India and 7.63x for Punjab National Bank, to around 13.13x for State Bank of India, and up to 18.39x for HDFC Bank and 22.64x for Kotak Mahindra Bank. These figures suggest that while some public sector banks appear attractively valued based on current earnings multiples, the higher multiples for private sector banks like Kotak Mahindra reflect different growth expectations or market positioning. Analysts are divided on the immediate outlook for NIMs. Nomura believes the NIM downcycle has bottomed out and expects gradual improvement driven by deposit repricing, projecting an inflection point for profitability. However, CARE Ratings forecasts a decline in return on assets (RoTA) by 12-15 bps to around 1.15% in FY26 due to persistent NIM pressure and rising credit costs. The recent 25 bps repo rate cut in December 2025 is expected to create mixed NIM trends in the short term, with full transmission of lower deposit costs taking time.
The Bear Case: Funding Dependency and Competitive Lag
The core risk for Indian banks lies in their persistent reliance on market borrowings, particularly deposits, which constitute a significant portion of their liabilities, unlike many global counterparts who leverage market funding more extensively [cite: Source A]. The intense competition for these deposits, driven by both retail and institutional demand for higher yields, forces banks into a costly funding structure. This liability cost pressure, combined with the downward adjustment of asset yields due to falling policy rates, creates a structural disadvantage. Banks are effectively 'punished on both sides' – unable to lower their borrowing costs sufficiently while forced to reduce lending rates [cite: Source A]. This dual pressure, particularly on EBLR-linked loans, risks eroding profitability more persistently than in past cycles. Furthermore, the shift in household savings towards equities and mutual funds suggests a long-term challenge in attracting stable, low-cost retail funding, forcing greater reliance on potentially volatile and expensive bulk deposits. This structural vulnerability could limit the pace of NIM recovery even as policy rates stabilize or decline further.