Whalesbook
PSU Banks Show Resilience in Rate-Cut Cycle
State-owned banks have emerged as the relative winners in the Reserve Bank of India's (RBI) rate cut cycle, managing to protect their net interest margins (NIMs) far better than private-sector lenders. Even as the easing of policy rates put pressure on lending yields across the banking system, lower funding costs and a stronger, more stable deposit franchise helped public-sector banks (PSBs) cushion the impact.
According to data compiled by Moneycontrol, PSBs reported a contraction in NIMs in the range of 8–73 basis points in Q2FY26. In stark contrast, private banks saw a much sharper compression, with margins declining by 8–116 basis points during the same period. Examples of significant margin erosion include Bandhan Bank, which saw a 116 basis points decline, while ICICI Bank experienced a lesser, but still notable, erosion of 6 basis points. This performance divergence occurred against a backdrop of a cumulative 125 basis points rate cut by the RBI in 2025, intended to support economic growth.
Funding Costs & Deposit Mix Divergence
One of the primary drivers behind this performance difference has been the cost of funds. Public sector banks typically boast a higher proportion of low-cost Current and Savings Account (CASA) deposits. This robust, relationship-driven deposit franchise means these liabilities reprice more slowly, offering greater insulation when benchmark interest rates fall. Conversely, many private banks depend more heavily on bulk and market-linked deposits. These deposits reprice more quickly, potentially keeping funding costs elevated even as lending yields decline.
The banking system has seen loan yields decrease as the RBI implemented cumulative reductions in policy rates throughout 2025. However, the transmission of these rate cuts into bank margins has varied significantly between public and private sector entities. Experts highlight that deposit costs often lag behind the decline in lending rates, leading to a squeeze in banks' interest rate spreads.
RBI's Rate Transmission Dynamics
In response to the cumulative 100 basis points reduction in the policy repo rate from February to October 2025, banks generally reduced their external benchmark-based lending rates on fresh loans linked to the repo rate by a similar magnitude. The weighted average lending rates on both fresh and outstanding rupee loans also eased during this period. On the deposit side, banks notably reduced interest rates on fresh term deposits.
However, the transmission of these rate cuts differed. The decline in the weighted average lending rate on fresh and outstanding rupee loans was more pronounced for private banks compared to public sector banks. Regarding deposits, transmission was higher for public sector banks compared to private banks on fresh term deposits. Specifically, RBI data indicates that the transmission of a 100 bps rate cut on fresh rupee loans by PSU banks was 70 bps, whereas it stood at 105 bps for private banks. On the asset side for new loans, transmission was 57 bps for PSU banks and 90 bps for private banks. On the liability side, PSU banks led transmission with 104 bps on fresh deposits, against 99 bps for private banks.
Stable Outlook Amidst Rate Sensitivity
Despite the varied impact of rate cuts, the outlook for India’s banking sector remains stable for FY2026, according to Sachin Sachdeva, Vice President & Sector Head – Financial Sector Ratings at ICRA. Banks are not anticipated to face significant capital-raising needs, buoyed by healthy credit growth across retail and MSME segments. However, the anticipated improvement in net interest margins from Q3 FY2026 may see a slight delay due to the recent rate cuts. ICRA will continue to monitor margin trends and the credit quality of unsecured loans and the MSME sector amidst evolving global macroeconomic developments.
Impact
This news provides crucial insight for investors assessing the performance and relative strengths of public sector banks versus private banks. The ability of PSBs to better manage their Net Interest Margins during an interest rate easing cycle suggests a potential advantage in certain market conditions, which could influence investment strategies and asset allocation within the banking sector. This trend can impact investor confidence and potentially influence the valuations of these banking groups. Rating: 7/10.
Difficult Terms Explained
- NIM (Net Interest Margin): This is a profitability measure for banks, representing the difference between the interest income generated and the interest paid out, relative to the bank's interest-earning assets. It essentially indicates how effectively a bank earns profit from its lending and borrowing activities.
- CASA Deposits: Refers to Current Account and Savings Account deposits. These are typically low-cost liabilities for banks because they offer very low or zero interest rates, providing a stable and inexpensive source of funding.
- Basis Points (Bps): A unit of measure used in finance to denote the percentage change in a financial instrument. One basis point is equal to 0.01% or 1/100th of a percent. For example, a 100 basis point rate cut equals a 1% rate cut.
- Transmission: In monetary policy, transmission refers to the process and speed through which changes in a central bank's policy rates (like the RBI's repo rate) are passed on to lending and deposit rates in the broader economy and banking system.