Banking on Perfection in an Imperfect World

Indian banking and financial stocks are trading with remarkable confidence. Multiples are expanding, earnings forecasts remain buoyant, and foreign capital has returned selectively. The narrative is reassuring; balance sheets are clean, regulation is proactive, and credit growth is decent.

But markets rarely misprice because they lack information. They misprice because they over-extrapolate stability.

The issue is not whether Indian banks are healthier than they were a decade ago. They indeed are. The issue is whether current valuations embed risks that are increasingly visible in a world marked by trade fragmentation, technological disruption, uneven income growth and episodic governance lapses.

Finance ultimately rests on income arithmetic. Banks are leveraged claims on household wages and corporate profits. Yet the real economy is hardly booming. Global trade faces tariff uncertainty. Export-linked sectors see demand volatility. Service-sector employment, particularly in mid-tier IT and process outsourcing, faces gradual compression from automation and AI adoption. Urban wage growth has softened in pockets. Consumption is uneven rather than broad-based.

And still, financial stocks are priced for sustained double-digit credit growth, stable margins and contained stress.

If nominal income growth moderates structurally, credit expansion must either slow or invite future delinquency cycles. Markets appear to be pricing neither outcome meaningfully.

To be sure, the banking system is cleaner. Gross NPAs are far below their peak levels. Provisioning buffers are stronger. Capital adequacy is comfortable. Oversight by the Reserve Bank of India has tightened, particularly around unsecured retail lending.

But backwards-looking repair does not automatically translate into forward-looking protection.

This credit cycle is heavily retailised. Unsecured personal loans, credit cards, small-ticket MSME lending and consumer finance now drive incremental growth. That reduces the concentration risks that once plagued infrastructure lending. Yet it introduces a different vulnerability viz., diffuse stress linked to household income stability.

Retail stress does not explode dramatically; it accumulates gradually across millions of borrowers. Valuations today assume low credit costs will persist. That assumption may prove optimistic if employment elasticity weakens or wage growth stalls.

Governance adds another layer of fragility. The recent fraud episode involving IDFC First Bank is a reminder that control failures have not vanished. Fraud tends to emerge where growth pressure meets internal control gaps and incentive misalignment. Markets often dismiss such events as idiosyncratic. But valuation discipline requires pricing the probability of recurrence, not merely the scale of the last incident.

Rapid loan growth, competitive pressure in retail and MSME segments, and expanding distribution networks test underwriting standards. Governance risk is episodic by nature, which makes it easy to underestimate until it resurfaces.

Margins, too, deserve scepticism, since much of the optimism rests on strong net interest margins driven by loan repricing outpacing deposit repricing. Funding franchises has supported spreads. But margin strength is cyclical, not structural.

Deposit competition can intensify. Liquidity can tighten. Credit demand can moderate. A normalisation of spreads, even without a spike in NPAs, would compress return-on-equity projections. In a sector trading at premium price-to-book multiples, PEs commensurate with the intangible nature of business, even modest RoE downgrades can trigger disproportionate valuation adjustments.

Technological disruption, particularly from AI, is likely to be gradual rather than abrupt, yet even incremental compression in service-sector employment or wage growth has cascading effects on urban consumption, housing demand and discretionary borrowing. Banks do not require an employment collapse to feel pressure. They require expectations to outrun income reality.

Supporters of current valuations argue that India’s financial deepening is incomplete. Credit-to-GDP ratios remain lower than in developed markets. Household savings are increasingly financialised. Formalisation continues.

All valid points, but financialisation expands access; it does not create repayment capacity independent of income growth. Structural deepening can proceed even as growth moderates, but at a slower pace than current multiples imply.

Foreign investor enthusiasm further complicates the picture. Much of it reflects relative positioning. Compared to China’s property stress or Europe’s stagnation, India appears stable. Yet relative attractiveness is not a permanent valuation anchor. In periods of global risk aversion, capital retreats broadly.

None of this suggests imminent crisis. Indian banks are not systemically fragile. Capital buffers are stronger. Regulation is more intrusive. The probability of a repeat of the last decade’s asset quality shock is lower.

Lower probability, however, does not amount to negligible risk.

The sector is structurally stronger, yet valuations appear to assume that cyclical and structural risks have been permanently retired.

History offers a gentler lesson. Risk rarely disappears. It migrates from corporate leverage to household leverage, from infrastructure concentration to retail exuberance, from opaque balance sheets to governance lapses.

Finance can outperform the real economy for a time. It cannot detach from it indefinitely. Confidence in India’s banking system is justified, but premium valuations that assume a frictionless future may not be.

(This column reflects the author’s personal views and is based on publicly available information. It is intended for general commentary and analytical purposes only and should not be construed as investment advice.)