As the third quarter earnings season for fiscal year 2026 approaches, the Indian banking sector presents a picture of robust business momentum tempered by significant structural challenges. Brokerages anticipate that banks will report a steady recovery for the October-December quarter, driven by strong credit expansion, stable asset quality, and healthy capital reserves. However, the widening chasm between loan and deposit growth, leading to strained liquidity, is set to become a central focus for analysts and investors alike.
Credit Surge and the Mounting Liquidity Crunch
The fundamental driver for the quarter has been a notable acceleration in credit demand. According to the latest Reserve Bank of India data, non-food credit for the banking system grew by almost 12% year-on-year as of December 15. This marks a significant increase from the approximately 9% growth witnessed in May 2025, fueled by a consumption-led economic recovery and supportive regulatory measures.
Pre-quarter business updates from major lenders confirm that this credit momentum has carried through the December quarter. The flip side of this growth story is a worrying trend in deposit mobilization. Deposit growth has lagged considerably, registering at a little over 9% year-on-year. This disparity has pushed the banking system's loan-to-deposit ratio (LDR) to a record high of over 81%, as flagged by Macquarie Research.
An even starker indicator is the incremental LDR, which soared to 102% in 2025 from 79% a year earlier. A ratio above 100% indicates that banks are lending out more money than the fresh deposits they are gathering. This unsustainable gap is forcing financial institutions to rely heavily on alternative sources to fund their lending activities.
Banks are increasingly leaning on market borrowings, liquidating excess statutory liquidity ratio (SLR) holdings, and dipping into balance-sheet buffers. The strain is evident at major private lenders like HDFC Bank, which reported its LDR at 98.6% on a net advances basis, up from 98% in the previous quarter.
Profitability and Asset Quality: A Mixed but Stable Outlook
On the profitability front, net interest margins (NIMs) for the December quarter are expected to remain largely stable. Analysts believe the full impact of the Reserve Bank's recent 25 basis points rate cut will be felt more meaningfully from the March quarter onwards. The complete transmission of earlier cash reserve ratio (CRR) cuts is seen providing a cushion to margins.
However, margins will continue to face pressure. YES Securities projects a sequential decline in NIMs for banks, clustering around a 5 basis points drop. The outcomes are expected to be divergent across institutions. Brokerages like Systematix Institutional Equities note that while yields on advances may decline, the positive impact from prior reductions in term deposit rates should become evident this quarter, supporting overall profitability.
A key positive for the sector is the continued improvement in asset quality. Stress is particularly easing in unsecured retail and microfinance portfolios, which should help contain credit costs. The broader health of the banking system remains robust, with system-wide stress at its lowest level in over a decade, non-performing loans near cyclical lows, and provision coverage ratios at record highs.
Earnings Season and Future Trajectory
The earnings season will kick off on January 17, with leading private sector banks like HDFC Bank, ICICI Bank, and YES Bank slated to announce their results. Market participants will keenly watch management commentary on loan and deposit growth targets, as well as guidance on net interest margins for the coming quarters.
Private sector banks are projected to post modest profit growth, while public sector banks are likely to see stable but slower earnings expansion amid flatter margins. The sector's capital adequacy provides a significant buffer, with common equity tier-1 (CET-1) ratios above 14.5% and liquidity coverage ratios exceeding 130%.
In summary, while Indian banks enter the Q3 FY26 earnings period on the back of strong credit growth and improving asset quality, the persistent weakness in deposit mobilization and the resulting liquidity tightness pose a critical challenge that will define their strategic choices in the near future.
