Indian Banks to Face Margin Pressure as Liquidity Tightens: Fitch

Indian banks could face renewed pressure on margins in 2026-27 as tighter liquidity conditions and elevated funding costs begin to weigh on profitability, even as their overall credit profiles remain stable, Fitch Ratings said in a note today.

The global rating agency expects that the Reserve Bank of India’s flexibility to inject liquidity into the banking system has narrowed in recent months, largely due to efforts to contain rupee volatility amid heightened geopolitical tensions. This shift, combined with persistent competition for deposits, could translate into higher funding costs and weaker margin performance across the sector.

Fitch estimates that sector net interest margins could decline by 20–30 basis points below its current forecast of 3.1% for 2026-27 if elevated funding costs persist, particularly due to ongoing tensions in the West Asia. Such compression would also weigh on core profitability, with operating profit relative to risk-weighted assets projected to fall by 30–40 basis points from the agency’s 2.5% baseline estimate.

Despite these pressures, Fitch maintains that Indian banks have adequate earnings buffers to absorb the impact without materially affecting their overall profitability assessment. Treasury gains, however, could come in moderately below earlier expectations, reflecting less favourable market conditions.

A key assumption underpinning Fitch’s earlier outlook was that deposit costs would ease in 2026-27, supported by accommodative liquidity and the transmission of cumulative policy rate cuts of 125 basis points since December 2024. However, transmission has been partial so far, with only about 44 basis points passed on to deposit rates as of January 2026. This lag reflects intensifying competition for deposits, as credit growth has continued to outpace deposit mobilisation.

In response to these imbalances, the RBI had increased durable liquidity in the system since second half of 2024-25 through measures such as government bond buybacks and open-market operations. The central bank has also signalled its intent to remain proactive in maintaining adequate liquidity conditions.

However, recent developments have complicated this stance. Banking system liquidity surplus has narrowed to about 0.5% of deposits as of late March 2026, down from around 0.8% a month earlier, amid sustained pressure on the rupee. The currency has depreciated by about 4.5% during this period, prompting the RBI to take steps to stabilise it. Such measures, while necessary for currency management, tend to drain local-currency liquidity from the banking system, thereby constraining the central bank’s ability to ease conditions further.

Fitch notes that rupee volatility itself is unlikely to pose a direct and material risk to Indian banks, given the predominantly domestic nature of their balance sheets. Overseas loans account for less than 10% of total sector lending, and net open foreign-currency positions are modest, at around 2.5% of equity as of the first nine months of FY25.

Moreover, most corporate borrowers with foreign-currency exposures typically hedge their positions, limiting the risk of asset-quality deterioration solely due to currency movements. Nonetheless, a prolonged period of rupee weakness, especially if accompanied by higher energy and raw material costs, could fuel inflationary pressures and weaken repayment capacity in more vulnerable segments such as small and medium enterprises.

The RBI’s directive requiring banks to unwind foreign exchange positions above $100 million underscores its focus on containing currency volatility. However, Fitch expects the impact of such measures on bank profitability to be minimal, noting that income from exchange transactions accounts for less than 0.1% of risk-weighted assets.

Looking ahead, Fitch sees potential for positive rating momentum if the operating environment improves. An upgrade in the operating environment score to ‘bbb-’ could support higher viability ratings, particularly if the RBI sustains its reform trajectory and India’s growth outlook remains strong.

Conversely, downside risks remain tied to external developments. A prolonged escalation in geopolitical tensions, particularly in the Middle East, could exert sustained pressure on energy prices and economic growth, potentially weakening the operating environment for banks.

Even in such a scenario, Fitch expects Indian banks’ Issuer Default Ratings to remain stable, supported by sovereign backing. India’s ‘BBB-’ sovereign rating, with a stable outlook, provides a buffer against moderate downside risks. However, outlooks on some private-sector banks could be revised to stable if broader operating environment expectations weaken.