Indian banks face a Q2 paradox: FCNR boosts loan growth but margins shrink

Banks are likely to report their strongest credit growth momentum in years in upcoming Q2 results, but the headline expansion comes with a catch. FCNR(B) deposits have lifted funding and helped accelerate loan books, while the resulting liquidity surplus, lower CASA ratios and higher deposit costs are expected to squeeze net interest margins (NIMs).

That tension is set to define the sector’s Q2F earnings season: stronger loan growth and lower credit costs on one side, but weaker margins and a less favourable funding mix on the other.

“FCNR flows take centre stage,” Kotak Institutional Equities said in a note, adding that the deposits would affect net interest margins in the current quarter and partly into the next.

FCNR flows lift headline growth

Banking system credit growth reached 19% year-on-year in August 2026, according to Systematix, compared with 11% a year earlier. Deposit growth also accelerated to 17.3% as of Sept. 15, from 12% in June.

The increase in deposits was supported by strong FCNR(B) mobilisation under the Reserve Bank of India’s swap window. Systematix said total FCNR(B) flows had reached $132.9 billion as of Aug. 31.

The resulting deposit growth has outpaced advances, creating surplus liquidity across the banking system and easing funding conditions. The system credit deposit ratio moderated to about 80.8% as of Sept. 15, from 83.4% three months earlier.

But a significant part of the reported growth at individual banks is linked to FCNR(B)-related activity.

At HDFC Bank, reported loan growth was 16.3% year-on-year. Nomura estimates that growth would have been 14.3% excluding loans extended against FCNR(B) deposits. Such loans accounted for about 35% of quarterly loan accretion.

At Bank of Baroda, overseas advances rose 22% sequentially and accounted for about 61% of incremental loans during the quarter, largely because of loans extended as leverage against customers’ FCNR(B) deposits.

Yes Bank’s reported net advances grew 8.6% sequentially, but growth excluding foreign currency term loans was only 3.3%. Those loans accounted for about 62% of incremental advances. “Look through the headline growth; funding quality is the differentiator,” Nomura said.

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Margins are the immediate casualty

The same flows that have helped banks grow their loan books are weighing on profitability.

FCNR(B) deposits have increased the share of term funding and diluted CASA ratios. At some banks, funding raised through the facility has not yet been fully deployed into loans or used to replace higher cost liabilities.

Kotak estimates that FCNR deposits could have a 10–15 basis-point quarterly impact on margins at large private banks. Systematix expects average net interest margins across its coverage universe to decline by about 7 basis points sequentially in Q2FY27.

The pressure is coming from multiple channels: lower CASA ratios, higher liquidity, an increase in the cost of deposits and the leverage provided for FCNR(B) deposits weighing on yields on advances.

Dolat Capital expects margins for its coverage banks to decline by 4–5 basis points sequentially, even as net interest income grows 14% year-on-year on the back of strong loan growth.

The margin outlook could become more complicated if rates rise in the coming quarters. The research firm said a potential rate hike and higher treasury yields would also put pressure on margins at non-bank lenders.

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Earnings growth remains intact

Despite the margin pressure, analysts expect the sector to deliver healthy earnings growth because of strong advances and lower credit costs.

Systematix expects profit after tax for its coverage universe, excluding IndusInd Bank, to grow about 15% year-on-year. It expects earnings growth to be led by advances and stable or lower provisioning costs.

Dolat Capital expects 19% year-on-year PAT growth for its coverage banks, though part of that increase is optical because of a higher credit-cost base for Axis Bank and the impact of a fund infusion at RBL Bank.

Kotak expects earnings for its coverage banks to rise 11% year-on-year. It sees private banks reporting 20% earnings growth, while PSU banks could report a marginal year-on-year decline after factoring in a recent Bank of Baroda disclosure.

Net interest income is expected to grow between 11% and 14% across the various brokerages’ coverage universes, despite the anticipated margin contraction.

Treasury income, however, is expected to weaken as higher government bond yields reduce trading gains. Systematix expects treasury income to decline sequentially at most banks, although SBI could benefit from a one-off gain of about ₹1,020 crore from the sale of stakes in SBI Funds Management and NSE.

Asset quality remains a cushion

The positive offset is that asset quality has not shown significant deterioration.

Kotak said its channel checks indicated that asset quality remained healthy, with no major concerns across loan portfolios. It also said that concerns linked to microfinance and other unsecured lending segments were showing consistent improvement.

Systematix expects fresh slippages to remain stable or decline sequentially at most banks, resulting in broadly stable credit costs. Dolat Capital also expects lower provisions to support earnings.

Nomura reported stable collection efficiency at Bandhan Bank, with overall collection efficiency at 98.9% in September. Microfinance collection efficiency stood at 98.6%.

However, the reports identify forward flows into stressed loan categories, standard asset provisions related to FCNR-linked deployment and any deterioration in borrower quality as key monitorables.

Large private banks preferred

The divergence between headline growth and underlying funding quality is likely to make bank selection more important during the earnings season.

Kotak prefers frontline banks over mid-tier, regional and small finance banks. It said large private banks remain the preferred way to position for potential multiple expansion, citing stronger balance sheets and easing non-financial overhangs, particularly at HDFC Bank.

The brokerage believes the full benefit of FCNR inflows should become more visible by the third quarter, once excess funding is deployed or used to replace expensive liabilities.

Systematix’s top picks are ICICI Bank, State Bank of India and Kotak Mahindra Bank. Jefferies has also highlighted strong growth at HDFC Bank, Axis Bank, Kotak Mahindra Bank and IDFC First Bank, while AU Small Finance Bank remains one of its preferred names because of strong loan and deposit growth.

(Disclaimer: This article has been written by Nikhil Agarwal, who is not a SEBI-registered Research Analyst or an Investment Adviser. Nikhil Agarwal and his/her ‘relative(s)’ (as defined under Section 2(77) of the Companies Act, 2013) do not hold any financial interest in the companies mentioned in this article as of the date of publication. The views/recommendations mentioned in this article, wherever applicable, are those of the respective SEBI-registered Research Analyst/brokerage and have been reproduced/reported with due attribution. They should not be construed as the views or recommendations of The Economic Times Digital or the journalist. Readers are advised to consider the original research report and make their investment decisions based on their own assessment. Brokerage disclaimers here)