Improving Asset Quality, Healthy Loan Growth and Lower Credit Costs Put NBFCs on Stronger Footing

India's Non-Banking Financial Company (NBFC) sector appears to be entering a more durable phase of recovery, with the first quarter of FY27 showing simultaneous improvement in loan growth, asset quality, margins and profitability.

According to Motilal Oswal Financial Services (MOFSL), the current recovery is different from earlier periods when NBFC earnings were largely supported by provision reversals and lower-than-expected credit costs.

This time, several operating factors are moving in the same direction. Healthy credit demand, moderating credit costs, resilient margins and improving operating leverage are collectively supporting the sector's earnings outlook.

The recovery is also becoming broader, extending beyond vehicle finance to diversified lenders, housing finance companies and microfinance institutions.

Among its preferred stocks, MOFSL has assigned a ₹380 target price to L&T Finance and a ₹1,390 target price to PNB Housing Finance.

NBFC Recovery Is Becoming Broad-Based

The NBFC sector had gone through a challenging period marked by elevated credit costs, stress in microfinance and unsecured lending, high funding costs and slower credit demand in certain segments.

The latest trends indicate that these pressures are gradually easing.

Loan growth has remained healthy across secured and selected unsecured segments, while asset quality has improved.

MOFSL believes this combination could support a sustained earnings upgrade cycle rather than a short-term recovery.

The brokerage expects the sector to benefit from:

• Healthy retail credit demand

• Moderating credit costs

• Improving collection efficiency

• Resilient net interest margins

• Lower funding-cost pressure

• Better operating leverage

• Increasing technology adoption

• More disciplined underwriting

Asset Quality Emerges as the Biggest Positive

Asset quality has been the most significant positive surprise for the NBFC sector.

After nearly two years of stress across microfinance, unsecured personal and business loans and selected retail portfolios, fresh slippages have moderated and collection efficiency has improved.

MOFSL attributes the improvement to several factors, including tighter underwriting, stronger collection infrastructure, greater use of analytics and an increasing focus on secured lending.

This matters because lower credit costs can have a direct impact on profitability.

If fresh slippages remain under control, lenders may be able to reduce provisions and redirect capital towards growth.

Microfinance Shows Early Signs of Stabilisation

Microfinance was among the segments that experienced significant stress during the previous cycle.

However, the latest trends indicate early signs of stabilisation.

The recovery remains at an early stage, but improving collections and moderation in fresh slippages could provide relief to lenders with exposure to microfinance and micro-LAP.

A gradual recovery in disbursements combined with lower credit costs could create significant operating leverage for companies operating in these segments.

The Reserve Bank of India had also reported that microfinance credit increased for the first time after seven consecutive quarters of decline during the January-March 2026 quarter, although the borrower base continued to contract.

This suggests that lending activity is beginning to recover, but the sector is still undergoing consolidation.

Loan Growth Remains Healthy

The recovery is not limited to asset quality.

Loan growth remains healthy across several lending segments, supported by rising formalisation of credit, improving consumer balance sheets and sustained demand.

Housing

Housing finance companies are witnessing steady disbursements, particularly in affordable and mid-income housing.

Vehicle Finance

Vehicle financiers continue to benefit from healthy automobile volumes, replacement demand and improving used-vehicle financing.

MSME Lending

Demand from small businesses and self-employed borrowers is providing another avenue for NBFC growth.

Personal Loans

Diversified lenders are seeing improving traction in personal and other retail lending, although underwriting remains more selective than during the previous expansion cycle.

Lenders Are Prioritising Profitability Over Market Share

An important structural change is the greater emphasis on risk-adjusted returns rather than simply maximising loan growth.

During aggressive credit cycles, lenders can sometimes prioritise market share at the expense of pricing and asset quality.

The current environment is different.

NBFCs are increasingly calibrating disbursements based on expected profitability, borrower quality and risk.

This discipline could make the current recovery more sustainable.

Funding Costs Could Provide Additional Relief

The easing in bond yields has provided some relief to NBFC borrowing costs.

For lenders that rely heavily on market-linked funding, lower funding costs can support margins and profitability.

However, funding conditions remain sensitive to several macroeconomic factors, including:

• Inflation

• System liquidity

• Interest rates

• Bond yields

• Global risk sentiment

• Geopolitical developments

A sustained moderation in funding costs would provide another positive catalyst for NBFC earnings.

Margins Remain Resilient

Despite some moderation in lending yields, NBFC margins have remained relatively resilient.

Housing finance companies continue to face pressure because of intense competition and elevated incremental borrowing costs.

However, stable asset quality can provide a cushion against margin pressure.

For diversified NBFCs, the ability to shift capital towards segments offering better risk-adjusted returns could also help protect profitability.

Operating Leverage Could Accelerate Earnings Growth

Technology investments made over the past few years are increasingly becoming important earnings drivers.

NBFCs have invested in:

• Digital sourcing

• Artificial intelligence

• Data analytics

• Automated underwriting

• Centralised operations

• Digital collections

• Customer-service platforms

As loan growth improves, these investments can help spread fixed operating costs over a larger loan book.

This could result in operating profit growing faster than the underlying business.

MOFSL therefore sees operating leverage as an increasingly important driver of return ratios.

L&T Finance: MOFSL Target Price ₹380

Diversified Retail Lending Provides Multiple Growth Engines

MOFSL remains positive on L&T Finance, which it believes is well positioned for sustained retail growth.

The company's lending portfolio includes businesses such as:

• Rural business finance

• Gold loans

• Personal loans

• Other retail lending segments

The diversified portfolio provides multiple avenues for growth and allows the company to allocate capital according to risk-adjusted returns.

Strong Q1FY27 Performance

L&T Finance reported a strong first quarter of FY27.

Its consolidated net profit increased 31% year-on-year to ₹916 crore, while the consolidated loan book expanded 27% year-on-year to ₹1.30 trillion as of June 2026.

The retail loan book grew 28% to ₹1.28 trillion, while retail disbursements increased 36% to ₹23,852 crore.

The strong retail performance supports MOFSL's view that L&T Finance is entering a period of sustained growth.

Disciplined Approach to Growth

One of the key positives highlighted by MOFSL is L&T Finance's willingness to moderate disbursements selectively when necessary to protect asset quality.

This approach indicates that the company is prioritising sustainable profitability rather than pursuing loan growth at any cost.

Such discipline could prove valuable if competition increases across retail lending.

AI and Technology Could Improve Return Ratios

L&T Finance's technology-led strategy is another important component of the investment thesis.

The company has been investing in artificial intelligence, automation and digital processes to improve customer acquisition, underwriting, collections and operational efficiency.

As the retail loan book scales, these investments could improve cost efficiency and support higher return ratios.

MOFSL Expects 30% PAT CAGR

MOFSL estimates approximately:

• 25% loan-book CAGR during FY26-FY28E

• 30% PAT CAGR during FY26-FY28E

• FY28E RoA of around 2.6%

• FY28E RoE of around 15%

The brokerage has assigned a ₹380 target price to L&T Finance.

With L&T Finance trading around ₹321 at the time of the latest market data, the ₹380 target implies potential upside of roughly 18%, although the actual return will depend on market movements.

PNB Housing Finance: MOFSL Target Price ₹1,390

Affordable and Emerging Housing Could Drive Growth

PNB Housing Finance is another key MOFSL pick.

The company is positioned to benefit from increasing traction in:

• Affordable housing

• Emerging housing

• Deeper customer penetration

• Micro-housing finance

The housing-finance opportunity remains attractive as formalisation of income and improving access to mortgage finance support demand.

Margin Recovery Expected From 2HFY27

PNB Housing Finance experienced moderation in NIMs during Q1FY27.

However, management expects margins to improve from the second half of FY27.

The expected recovery could be supported by:

• Better business mix

• Higher incremental yields

• Lower funding costs

• Improved lending economics

If funding costs moderate as expected, margin recovery could become an important earnings catalyst.

Asset Quality Remains Supportive

Asset quality continues to be a key strength.

MOFSL highlighted healthy asset quality, declining repayments and continued recoveries.

The company's affordable-housing portfolio has also shown improving asset-quality indicators in recent periods. MOFSL's research data showed gross NPA in affordable housing remaining at low levels through FY26.

Stable asset quality can provide greater confidence as PNB Housing Finance accelerates growth.

Micro-Housing Finance Adds a New Growth Opportunity

The upcoming micro-housing finance rollout could expand PNB Housing Finance's addressable customer base.

This segment could help the company reach borrowers who remain underserved by traditional housing-finance providers.

However, investors will need to monitor the asset-quality profile of this portfolio as it scales.

Q1FY27 Numbers Show Revenue Growth

PNB Housing Finance reported consolidated revenue of ₹2,263.44 crore in Q1FY27, up 9.02% year-on-year.

Operating profit increased 8.93% year-on-year to ₹2,042.37 crore.

The numbers show continued business growth, although sequential pressure on PBDT and profit before tax highlights the importance of the expected margin recovery.

MOFSL Expects 21% Loan CAGR

MOFSL estimates:

• 21% loan CAGR during FY26-FY28E

• 13% PAT CAGR during FY26-FY28E

• FY28E RoA of around 2.3%

• FY28E RoE of around 13%

The brokerage has assigned a ₹1,390 target price to PNB Housing Finance.

The stock was around ₹1,138-₹1,149 around the latest available market sessions, implying potential upside of approximately 21% to 22% to MOFSL's target, depending on the reference price.

Competitive Dynamics Are Changing

The NBFC industry is becoming increasingly competitive.

Large diversified lenders with strong liability franchises and multiple lending products have greater flexibility to move capital between segments.

This allows them to focus on businesses offering stronger risk-adjusted returns.

Smaller or monoline lenders can be more vulnerable when a particular lending segment enters a downturn.

This makes scale, funding access and diversification increasingly important competitive advantages.

Gold Finance: Strong Demand but Rising Competition

Gold finance remains a strong growth segment because of high collateral values and consumer demand.

However, the entry of well-capitalised lenders is increasing competition.

Over time, this could lead to:

• Lower lending yields

• Pricing pressure

• Lower spreads

• Higher customer-acquisition costs

Therefore, strong loan growth in gold finance should not automatically be interpreted as equivalent to strong earnings growth.

Regulatory Developments Remain a Key Monitorable

The NBFC sector remains sensitive to regulatory changes.

MOFSL highlighted developments relating to revolving credit products and insurance commissions as areas that could affect product economics and fee income.

Investors should therefore monitor regulatory announcements alongside quarterly financial performance.

Changes in capital requirements, lending standards or product structures can influence both growth and profitability.

What Could Drive the Next NBFC Earnings Upgrade?

The next leg of the NBFC earnings cycle could be driven by five major factors.

Lower Credit Costs

Further improvement in collection efficiency could reduce provisions.

Stronger Loan Growth

Continued demand from housing, vehicles, MSMEs and retail consumers would support loan expansion.

Lower Funding Costs

A favourable interest-rate environment could improve spreads.

Operating Leverage

Higher loan growth could improve cost absorption.

Better Return Ratios

The combination of lower credit costs and operating leverage could improve RoA and RoE.

Key Risks for NBFC Investors

Asset Quality Could Deteriorate Again

The current improvement needs to be sustained over several quarters.

Any reversal in collection efficiency or increase in fresh slippages could push credit costs higher again.

Competition Could Pressure Margins

Aggressive lending competition could force NBFCs to reduce lending rates, affecting NIMs.

Funding Costs Remain Macro-Sensitive

A rise in bond yields or tighter liquidity could increase borrowing costs.

Regulatory Risk

Changes to lending norms, capital requirements or financial-product regulations could affect earnings.

Economic Slowdown

A slowdown in employment, consumption or business activity could weaken credit demand and increase defaults.

L&T Finance vs PNB Housing Finance

Key Metrics Investors Should Track

For the NBFC sector, investors should look beyond headline loan growth.

The most important quarterly indicators include:

• Loan-book growth

• Retail disbursement growth

• Fresh slippages

• Gross NPA

• Net NPA

• Collection efficiency

• Credit costs

• Net interest margin

• Cost-to-income ratio

• Funding costs

• Operating cash flow

• RoA

• RoE

• Capital adequacy

The strongest confirmation of a durable recovery would be a combination of double-digit loan growth, stable asset quality, declining credit costs and improving RoA/RoE.

NBFCs Could Enter a New Earnings Cycle

The current recovery is important because it is no longer dependent on one single earnings lever.

Loan growth is improving.

Asset quality is stabilising.

Credit costs are moderating.

Margins remain resilient.

Technology investments are improving operating efficiency.

If these trends continue simultaneously, NBFCs could enter a more sustainable earnings-growth cycle over FY27 and FY28.

MOFSL's broader sector view has also identified several top picks, including Bajaj Finance, L&T Finance, PNB Housing Finance and Five-Star Business Finance, reflecting its expectation that earnings upgrades could continue as the recovery broadens.

Market Outlook

The NBFC sector appears to be transitioning from a balance-sheet repair cycle to a growth and profitability cycle.

The most encouraging development is the improvement in asset quality after nearly two years of stress. Better collections and lower fresh slippages can provide a direct boost to earnings through declining credit costs.

At the same time, continued demand for housing, vehicles, MSME loans and retail credit should support loan-book expansion.

Among MOFSL's preferred stocks, L&T Finance stands out for its diversified retail-lending model and stronger expected earnings growth. The brokerage forecasts approximately 25% loan-book CAGR and 30% PAT CAGR through FY28E, with RoA and RoE expected to improve. Its ₹380 target suggests meaningful upside from recent trading levels.

PNB Housing Finance offers a more focused housing-finance opportunity, with affordable and emerging housing expected to drive growth. Margin recovery from 2HFY27, stable asset quality and micro-housing expansion are key potential catalysts. MOFSL's ₹1,390 target represents roughly 20%+ potential upside from recent levels.

However, investors should remain selective. Competition, funding costs, regulatory changes and any renewed deterioration in asset quality remain the key risks.

Overall, if credit demand remains healthy and funding costs moderate while asset quality continues to improve, NBFCs could witness a durable earnings upgrade cycle through FY27-FY28. The strongest opportunities are likely to remain with lenders that combine strong underwriting, diversified portfolios, stable funding access, technology-led efficiency and improving return ratios.