Foreign investors are coming back to India, but still skipping banks.

By almost every measure a bank is usually judged on, Indian banking is in good shape right now. Credit is growing at its fastest pace since 2024, bad loans have fallen to a multi-decade low of 1.8% of advances, and capital buffers sit at 17.7%, nearly double the regulatory floor.

None of that stopped foreign institutional investors (FIIs) from cutting their holdings in India's two largest private banks over the June quarter.

Source: ACE Equities shareholding data

That said, not all banks have been similarly impacted. ICICI Bank was barely touched, similarly Federal Bank has actually seen an increase. But that said, as the flows below suggest, the sector as a whole has been hugely impacted.

Source: NSDL FPI fortnightly and monthly sector-wise data

Being the most-sold sector is not the same as being the least-wanted one. To a certain extent this outflow also represents the size of the sector in the index.

So, what really is going on?

Why the cold shoulder, if the loan book looks fine? Almost every large bank reported higher profit for the June quarter. Several of their share prices fell on the day anyway, because the market was reading past the profit line to the margin underneath it.

Source: Q1 FY27 company disclosures, compiled by INDmoney

One of the industry leader is clearly facing some challenging times. HDFC Bank is the clearest case, and it's worth separating from the pack. Its June-quarter margin was the lowest it has ever recorded. That traces back to its 2023 merger, which loaded the bank with more expensive borrowings right as savers moved money out of savings accounts and into fixed deposits.

The bank isn't lending badly; it's funding itself expensively. A bad-loan problem is usually fixable within a couple of quarters. A liability-mix problem only unwinds as old, cheap deposits mature and get replaced — a clock that doesn't move faster just because the stock looks cheap.

Credit growth is good, but margins could be challenged

The credit growth that's arriving is skewed the wrong way for margins. Services and industry, priced thin because large borrowers can shop the market for the best rate, are doing the heavy lifting. Personal loans and credit cards — among the highest-yielding products a bank sells — are the slowest-growing segment on the list. Volume is up. Earnings per rupee lent are not.

Source: RBI, Sectoral Deployment of Bank Credit, July 2026

Even the recent deposit relief comes with a footnote. Almost all of the improvement in credit-deposit ratios arrived in a single fortnight, driven overwhelmingly by FCNR(B), a window for NRI deposits that has since closed. That sets up an awkward comparison for the December quarter: deposit growth will look weaker from here even though nothing about the underlying business has changed.

So, what does this mean for banks?

Three things sit in the sector's favour. Foreign holdings have fallen far enough that index providers could raise banking's weight, and passive money follows the weight rather than the story. HDFC Bank, Kotak and Axis all trade below their own historical averages. And the rate cuts that caused the margin pain look done — once rates stop falling, expensive old deposits keep rolling off while loan pricing stops sliding, which is exactly how margins recover.

The counter-argument deserves equal space. Public sector banks have beaten private banks for three straight calendar years.

The valuation case is partly circular — these banks look cheap next to their own history because their margin outlook is worse than their own history. And the rate-cycle argument, the strongest bullish point on the table, isn't specific to private banks at all: it helps every lender in the system, including the public sector banks that are already winning.