India's Banking Sector: The Rate Cut Cycle and the Sustainability of Profitability

The Reserve Bank of India has delivered a decisive policy easing, cutting its key repo rate by a total of 125 bps since the beginning of the year to reach 5.25% by December. This aggressive cycle, complemented by targeted liquidity injections like open market operations worth INR 1 trillion and USD 5 billion in forex swaps, was designed to fuel a growth rebound. The central bank's confidence in a softening inflationary outlook has been vindicated, with headline inflation revised down to 2.0% and the RBI raising its GDP growth forecast for FY2025/26 to 7.3%. This creates a powerful macro engine: lower borrowing costs are intended to stimulate investment and consumption, while a solid growth trajectory supports loan demand and asset quality.

For banks, this policy shift presents a classic cyclical opportunity. The transmission of these lower rates to their balance sheets, however, is uneven. While the cost of funds for banks has fallen, the repricing of deposits-especially retail savings-has been slower. This lag has helped stabilize net interest margins (NIMs) for some large lenders, providing a buffer against the immediate pressure of the rate cuts. The setup is clear: the RBI's easing cycle is actively supporting the economic expansion that banks need, while some institutions are navigating the NIM compression with relative resilience.

Yet this macro boost sets the stage for the core sustainability challenge. The cyclical tailwind to profitability is real, but it is built on a foundation that still bears structural imbalances. The question for investors is whether this rebound is a temporary fillip or the start of a durable expansion in earnings power. The answer hinges on how quickly banks can manage the deposit-cost drag and whether the growth engine can be sustained beyond the initial policy push.

The Profitability Equation: Credit Growth vs. Funding Costs

The third-quarter earnings season for Indian banks is set against a backdrop of powerful, yet conflicting, forces. On one side, credit growth is surging, providing a robust top-line engine. On the other, weak deposit mobilization is straining the funding base, threatening to cap the upside for net interest margins. The sustainability of profitability hinges on how well banks navigate this tension.

The strength of loan demand is undeniable. Non-food credit for the banking sector grew at an almost 12% year-on-year as of 15 December, a significant acceleration from around 9% in May. This pickup is driven by a consumption-led recovery and supportive regulatory measures, including the full implementation of the RBI's 100-basis-point cash reserve ratio cut. The momentum appears to have sustained into the December quarter, with early numbers suggesting robust growth, particularly for large lenders. Yet, this growth is not without a recent, staggering anomaly. In the closing days of 2025, the sector witnessed an extraordinary event: a staggering INR 6.3 trillion expansion in bank credit over the fortnight ending December 31. This surge propelled annual credit growth to 14.5%, raising immediate questions about its sustainability. Analysts view this as a rare and potentially ephemeral outlier, a statistical blip that may not reflect underlying economic vigor but rather a temporary shift in corporate funding preferences amid liquidity pressures.

This explosive credit growth has exposed a critical imbalance: weak deposit mobilization. While credit is expanding, deposit growth has lagged, coming in at a little over 9% year-on-year. This widening gap is forcing banks to rely more heavily on market borrowings to fund their loans, stretching liquidity conditions. The result is a record-high loan-to-deposit ratio (LDR) for the system, which has climbed to over 81%. An LDR above 100% indicates banks are lending more than they are depositing, a situation that caps the upside for net interest margins even as loan yields fall. As Macquarie Capital noted, if this persists, banks may have limited room to pass on RBI rate cuts, a direct pressure on profitability.

The bottom line is a sector caught between two powerful currents. The cyclical rebound in credit demand is providing a clear tailwind to net interest income. However, the structural challenge of funding this growth with insufficient low-cost deposits creates a persistent drag. For banks to convert this credit momentum into sustainable, high-quality earnings, they must find a way to close the deposit gap or manage their liquidity costs more efficiently. The coming earnings reports will test whether their balance sheets are resilient enough to handle this equation.

Asset Quality and the Path to Sustained Earnings

The foundation for a durable earnings recovery is being laid on a surprisingly solid balance sheet. While the sector grapples with funding pressures, asset quality remains robust, providing a critical buffer. The gross non-performing asset (NPA) additions for the banking system have been declining sequentially, and the net NPA ratio sits at a remarkably low 0.39%. This is a structural strength, not a cyclical blip. It signals that the credit growth surge is being supported by quality borrowers, and the provisions cycle appears to be turning lower. For investors, this means the earnings rebound is not being built on a foundation of hidden risk.

Looking ahead, brokerage estimates point to a steady, if modest, acceleration in profitability for the December quarter. Analysts expect private sector banks to post average profit after tax growth of about 3.5%-5% year-on-year, a meaningful improvement from the 2% rise in the same period last year. The engine for this uptick is clear: net interest income (NII) is expected to see a sequential uptick, driven by the strengthening loan growth. This aligns with the broader narrative of a recovering credit cycle, where banks are finally able to lend more profitably as the economy expands.

Yet the path to sustained earnings is not without friction. The sector's performance will hinge on two critical, interlinked factors. First is the pace of deposit repricing. As long as banks are forced to fund their expanding loan books with higher-cost market borrowings, the upside for net interest margins will be capped, even as loan yields fall. Second is the durability of credit growth beyond the current cyclical upswing. The recent surge in credit, while impressive, must be converted into consistent, high-quality lending over the coming quarters to justify the sector's valuation.

The bottom line is a sector in a transitional phase. The asset quality backdrop is strong, and the near-term earnings trajectory is positive. But the sustainability of this recovery depends on banks successfully managing the deposit-cost drag and proving that the current credit momentum is more than a temporary fillip. The coming earnings reports will test whether the sector can navigate this tightrope.

Catalysts, Risks, and the Forward View

The path from a steady earnings recovery to a sustained expansion in profitability now hinges on a few critical catalysts and a persistent structural risk. The immediate focal point is the Reserve Bank of India's February Monetary Policy Committee (MPC) meeting, scheduled for February 4-6. This gathering coincides with the presentation of the Union Budget, creating a high-stakes moment for market expectations. Economists widely anticipate the MPC will keep its repo rate unchanged, as the central bank waits for data from the new base-year inflation series. This pause is expected, but the real focus will shift to the scale and timing of liquidity support. With system liquidity already tight and the RBI needing to inject funds to ease borrowing costs, the size of upcoming open market operations will be a key signal for bank funding conditions.

The primary risk that could derail the profit recovery, however, is not a policy misstep but a balance sheet constraint. Weak deposit mobilization continues to cap the upside for net interest margins. Even as the RBI's rate cuts lower the cost of funds, banks are forced to rely on more expensive market borrowings to fund a loan book that is growing faster than deposits. The loan-to-deposit ratio has climbed to a record over 81%, and an incremental LDR ratio above 100% means banks are lending more than they are depositing. As Macquarie Capital noted, if this persists, banks have limited room to pass RBI rate cuts, a direct pressure on NIMs that brokerage estimates already factor in. The sustainability of the sector's earnings depends on banks finding a way to close this deposit gap or manage their costly funding more efficiently.

The March quarter will provide the first clear signal on whether this risk is being mitigated. Analysts expect this period to benefit from deposit repricing and a pickup in unsecured retail lending segments like microfinance and credit cards. A successful repricing of deposits would directly ease the funding cost drag, while a genuine acceleration in retail credit growth would demonstrate that the credit cycle is broadening beyond corporate and consumption loans. This would be the clearest evidence that the sector's profitability is transitioning from a cyclical rebound to a more durable, high-quality expansion. For now, the setup is one of cautious optimism: the macro engine is running, asset quality is strong, but the forward view depends entirely on banks solving the deposit puzzle.