PSU vs private banks: The real story behind the Q2 divergence

Synopsis

Public sector banks are experiencing stronger net interest margin growth compared to their private counterparts this quarter. Despite facing margin pressures, private banks continue to show growth in profits and loan portfolios. The rising costs associated with funding and foreign currency deposits are impacting private banks' profitability. Corporate loan advances are increasing faster than retail loans across multiple private institutions.

The Q2 FY27 banking results have exposed a growing divide between public sector banks and their private peers. Public sector banks are reporting stronger net interest margin momentum, while large private lenders are absorbing the cost of raising deposits to sustain credit growth.

The gap is not simply about which banks are earning more from loans. It reflects a shift in funding economics, with foreign currency deposits temporarily weighing on private lenders’ profitability. The bigger question is whether this marks a lasting change in competitive strength or a temporary distortion in an otherwise healthy banking cycle.

Margin pressure reveals a funding problem

Net interest margins (NIMs) at select public sector banks rose 10 basis points sequentially to 2.58% in Q2, while private banks’ margins remained flat at 3.29%, as per a CareEdge Ratings analysis reported by ETBFSI. On a year-on-year basis, PSU bank margins improved 15 basis points, whereas private bank margins fell eight basis points.

The difference becomes sharper when looking at large private lenders. Their NIMs declined 12 basis points year on year to 3.33%. Other private banks, by contrast, recorded a 22-basis-point improvement to 3.06%, suggesting the pressure is concentrated among larger lenders rather than spread uniformly across the private sector.

Live Events

The underlying numbers explain the divergence. PSU banks’ lending yields increased 18 basis points sequentially against a nine-basis-point rise in funding costs. Private banks saw lending yields rise just six basis points while their funding costs increased 14 basis points, according to ETBFSI report.

The result is a squeeze on the incremental income private banks earn from lending. Their absolute margins remain higher than those of PSU banks, but the direction of change currently favours state-owned lenders.

FCNR(B) deposits are distorting the comparison

The biggest factor behind the private banks’ margin pressure is the mobilisation of Foreign Currency Non-Resident (Bank), or FCNR(B), deposits under the Reserve Bank of India’s special swap window.

Large private banks faced lower margins because of the cost of these deposits and the relatively low margins on lending backed by the funds. The deposits helped strengthen funding availability, but the benefit to earnings has not fully materialised. HDFC Bank, ICICI Bank and Axis Bank have faced this issue. HDFC Bank’s NIM fell 10 basis points sequentially to 3.16%, while Axis Bank’s declined to 3.36%. Both lenders attributed part of the pressure to FCNR(B) mobilisation. These inflows can make headline deposit growth look stronger without immediately improving profitability. Banks incur funding costs as the deposits come in, while the income benefit depends on how quickly the money is deployed into loans or used to replace more expensive liabilities.

Axis Bank had reportedly used some of its funds to retire higher-cost non-retail term deposits, with the benefit expected to emerge in subsequent quarters. ICICI Bank had also deployed part of its FCNR(B) funds, with further deployment planned.

The current margin hit does not necessarily indicate weak loan demand or deteriorating franchise strength. It partly reflects the timing mismatch between raising funds and earning returns on them.

Loan growth is holding up, but the mix is changing

The margin squeeze has not stopped private banks from growing. Their earnings announcements show that the pressure on NIMs has not translated into a broad-based deterioration in profits. Axis Bank’s net profit rose 38% year on year to Rs 7,003 crore in Q2 FY27. ICICI Bank reported a 20.1% increase to Rs 14,843 crore, while Kotak Mahindra Bank’s profit grew 29% to ₹4,212 crore.

HDFC Bank’s profit rose a more modest 4.7% to Rs 19,510 crore, despite 9.7% growth in net interest income. Corporate and business banking loans were growing faster than retail advances at several private lenders. ICICI Bank’s business banking portfolio expanded 33.8% year on year, while domestic corporate loans grew 30.6%. Axis Bank’s corporate advances increased 34%.

Banks are expanding through segments that may have different yields and funding requirements from traditional retail lending. Stronger loan growth can support interest income even when margins decline, but the impact on profitability depends on pricing and the returns earned on the additional assets.

Funding costs determine whether this growth translates into stronger core earnings. Private banks are not necessarily losing business. They are facing a higher cost of financing it.

PSU banks’ advantage is real, but it's not that simple

CareEdge’s figures show that select PSU banks grew net interest income by 18.4% year on year in Q2, compared with 14.4% for private banks. Interest income from advances increased 15.3% at PSUs against 14.1% at private lenders.

PSU banks also benefited from lower growth in interest expenses. These rose 7.1% year on year, while private banks recorded a 13% increase, partly reflecting 27% growth in term deposits.

Some state-owned lenders have been able to retire higher-cost bulk deposits, which helps reduce their funding burden. Their stronger margin performance therefore reflects both the repricing of loans and changes in the composition of liabilities.

However, the figures do not establish a wholesale shift in banking-sector leadership. The CareEdge comparison covers selected banks, and individual lenders continue to show considerable variation.

The PSU advantage is best understood as an improvement in current operating conditions rather than proof that public lenders have permanently overtaken private banks in business quality.

The rate cycle could narrow the gap

The outlook for the second half of FY27 depends partly on the RBI’s October repo rate increase of 25 basis points to 5.50%. Banks expect the change to support margins as external benchmark-linked loans reprice upwards. HDFC Bank’s management also expects a gradual improvement as floating-rate loans reset and the loan portfolio shifts towards better-yielding retail and MSME advances.

IndusInd Bank's adjusted NIM fell 12 basis points sequentially to 3.23%, but management expected some recovery as FCNR(B) funds were deployed into higher-yielding loans and the effect of rate increases began to emerge.

However, banks will need to manage the cost of deposits as they mature or renew. Any increase in deposit rates could offset the benefit of higher lending yields, while delayed deployment of FCNR(B) funds could extend the margin pressure.

What the divergence ultimately indicates

Q2 has exposed a difference in the cost of growth across India’s banking sector. PSU banks have converted lending activity into stronger margin expansion because their funding costs rose more slowly. Large private lenders have paid more to secure deposits, and the resulting earnings benefit has yet to fully emerge.

The next phase will depend on whether private banks can deploy their additional funding profitably. If they do, the current margin weakness could prove temporary. If deposit costs remain elevated, faster loan growth may continue to deliver less incremental profit than investors expect.

For PSU banks, the issue is whether the current margin gains can be sustained as competition for deposits intensifies. The Q2 numbers favour them on momentum, but the longer-term contest will still depend on returns, asset quality and the cost of maintaining growth.

(You can now subscribe to our Economic Times WhatsApp channel)

(Catch all the Business News, Breaking News and Latest News Updates on The Economic Times.)

Subscribe to The Economic Times Prime and read the ET ePaper online.

...moreless

(You can now subscribe to our Economic Times WhatsApp channel)

(Catch all the Business News, Breaking News and Latest News Updates on The Economic Times.)

Subscribe to The Economic Times Prime and read the ET ePaper online.

...moreless