Banking on NPAs: Why Rising Provisions Could Reshape Investor Bets on Financial Stocks

The numbers in India’s banking sector are telling two very different stories—bad loans are falling, but provisions are rising. Fresh data for Q1 FY26 shows a 9.5% year-on-year decline in bad loans, reflecting healthier credit discipline and stronger recoveries. Yet, provisions against non-performing assets (NPAs) jumped to a three-quarter high, led mainly by private banks. The contradiction is striking: fewer defaults, but bigger buffers.

Adding another layer, the new Income Tax Bill proposes to align NPA definitions and taxation rules with the Reserve Bank of India (RBI) norms—potentially reshaping how banks account for stress and how investors price financial stocks.

For traders and investors, this mix of optimism and caution signals a sector in transition, where balance sheet quality, provisioning strategies, and tax treatment could all influence valuations.

Understanding NPAs and Why They Matter

A non-performing asset is essentially a loan that has stopped generating income for the bank. Under RBI norms, any loan where principal or interest remains unpaid for more than 90 days must be classified as an NPA.

Banks further classify NPAs into three categories:

• Sub-Standard Assets: Overdue for less than 12 months but still recoverable; banks provision ~15%.

• Doubtful Assets: Unpaid for over 12 months with lower recovery prospects; provisions range between 25% and 40%.

• Loss Assets: Loans where recovery is nearly impossible; banks provision 100%.

Provisioning the amount banks set aside from profits to cover potential losses directly impacts profitability. A ₹10 crore loan turning doubtful, for example, may require provisioning up to ₹4 crore. While this safeguards the balance sheet, it also reduces near-term earnings.

Why Are Provisions Rising if NPAs Are Falling?

At first glance, this seems counterintuitive. But there are two key drivers:

1. Prudence Over Profit Banks, especially private ones, are adopting a proactive provisioning strategy. Rather than waiting for defaults to escalate, they’re fortifying their balance sheets early, essentially creating a financial “buffer” to absorb future shocks.

2. Regulatory and Tax Alignment The new Income Tax Bill aims to end long-standing disputes around when and how NPA-related income is taxed. Historically, there was a mismatch:

• RBI norms required banks to stop recognising interest income after 90 days of default.

• Tax rules, however, treated such interest as accrued income until 180 days had passed, often leading to taxation of income that wasn’t actually received.

This discrepancy caused significant litigation. The proposed changes now align the definition of bad and doubtful debts with RBI classifications, meaning banks will only be taxed on realised income.

Investor Implications: Balancing Short-Term Pain with Long-Term Gains

For traders, the rise in provisioning despite lower NPAs presents a classic short-term versus long-term dilemma.

1. Pressure on Profitability

Higher provisions weigh directly on quarterly earnings, which could lead to near-term volatility in financial stock prices. Expect private banks—particularly those aggressively cleaning up their books—to report muted profit growth despite healthy loan portfolios.

2. Stronger Balance Sheets Ahead

On the flip side, this provisioning discipline builds financial resilience. By absorbing potential shocks today, banks are positioning themselves to expand lending capacity tomorrow, especially as credit demand picks up in sectors like housing, MSMEs, and capital goods.

3. Sector Rotation Opportunities

Public sector banks (PSBs), which historically carried higher NPAs, have shown notable improvements in asset quality. As provisioning gaps narrow between PSBs and private banks, traders may see rotational opportunities within the sector.

4. Valuation Rethink

Banking valuations will increasingly hinge on provision coverage ratios rather than just net NPA levels. Investors looking at price-to-book multiples may need to account for how provisioning strategies differ across institutions.

How the New Tax Norms Change the Game

The alignment of tax treatment with RBI guidelines represents one of the most significant regulatory shifts in years. For investors, it has three big takeaways:

• Reduced Litigation Risk: Harmonising tax rules with prudential norms brings greater clarity, lowering the risk of retrospective disputes.

• Better Earnings Visibility: Banks can now plan around a single, unified framework, making financial statements easier to interpret.

• More Realistic Profitability Metrics: Since only realised income will be taxed, reported profits should more accurately reflect cash-based earnings.

This clarity benefits not just banks but also investors who track them, making it easier to distinguish between institutions with genuine profit growth and those simply benefiting from accounting anomalies.

Bottom Line for Traders

The Indian banking sector is at an inflection point. Falling NPAs suggest better credit hygiene, but rising provisions highlight continued caution. For traders, this duality presents both risks and opportunities.

In essence, while the headlines focus on bad loans, the deeper shift is in how banks are preparing for the future. For investors, this isn’t just about watching quarterly results—it’s about identifying the lenders that are building resilience today to lead the credit cycle tomorrow.

Read more:

Currency Under Pressure: How RBI’s $5 Billion Intervention Signals a Strategic Shift in India’s Forex Policy

Sources

The Economic Times
TaxGuru
Care Edge Ratings
The Economic Times
CA Club India
The Hindu Businessline