The first half of FY26 has shown that Indian banks are grappling with a significant challenge that is squeezing their profitability—rising cost of funds. Despite a healthy credit expansion of 11.3%, the overall profit growth for many banks has been surprisingly muted, with net profits inching up by only 2.5%. This unmistakably signals the strain that higher funding costs are placing on the banking sector’s earnings.

Banks traditionally make money from the spread between the interest they charge on loans and the interest they pay on deposits and borrowings. However, the landscape has shifted as funding costs have climbed. This means that while banks are lending more, the margin or spread they earn on each loan is getting tighter, reducing the incremental profit that loan growth would typically bring.

Several factors are contributing to this scenario. The Reserve Bank of India’s monetary policy tightening, aimed at controlling inflation and stabilizing the economy, has led to higher benchmark interest rates. Consequently, borrowing costs for banks have gone up, which they pass on only partially to customers, to remain competitive and manage credit demand. This partial pass-through causes banks to absorb higher costs, which compresses their net interest margins.

What does this mean for investors and stakeholders? The muted profit growth despite the credit boom suggests that banks’ earnings resilience is being tested. While credit growth points to sustained demand for loans—an encouraging sign for the economy—the squeeze on margins signals caution. Investors should closely watch how banks manage their funding costs going forward, especially if the rate environment remains elevated.

Interestingly, this trend is not unique to India. Globally, banks are facing similar headwinds as central banks hike interest rates to combat inflation. Even in markets where credit expansion is ongoing, the increase in the cost of funds is leading to profitability concerns. This could influence banking stock performances and sectoral valuations in global markets.

For the banks themselves, the focus will likely be on optimizing their liability mix, looking for cheaper sources of funds, and enhancing operational efficiency to protect profitability. Additionally, banks may explore repricing strategies on loans and deposits to better align with their rising costs.

In summary, while the growth in lending activity is a positive economic indicator, the rising cost of funds presents a clear challenge for banks’ profitability. The banking sector’s performance in the remainder of FY26 will hinge significantly on how well they can navigate the tight margin environment and adapt to ongoing macroeconomic conditions.

Investors and market watchers will want to keep a keen eye on quarterly earnings releases and policy developments to gauge the evolving impact of funding costs on banking profits. As the story unfolds, the balance between credit growth and cost management will be crucial for sustaining healthy bank earnings in a high-interest-rate world.