Karnataka Bank Q3 FY26: Asset Quality Improves But Margin Pressures Persist

The quarter's performance painted a mixed picture for the 102-year-old institution. Whilst net profit growth remained positive on an annual basis, the sequential decline of 8.88% from Q2 FY26's ₹319.12 crores raised questions about momentum sustainability. The bank's total income remained virtually flat quarter-on-quarter at ₹2,522.35 crores, declining marginally by 0.01%, though it showed resilience with a 0.74% year-on-year increase from the corresponding period last year.

Karnataka Bank's asset quality demonstrated notable improvement, with gross non-performing assets declining to 3.32% from 3.11% a year ago, whilst net NPAs compressed to 1.31% from 1.39% in Q3 FY25. This improvement in credit quality, coupled with a robust provision coverage ratio maintaining above 81%, underscored the bank's strengthening balance sheet fundamentals. The capital adequacy ratio stood at a comfortable 19.94%, providing substantial headroom for growth initiatives.

Financial Performance: Margin Compression Weighs on Profitability

The most striking feature of Q3 FY26 was the continued pressure on net interest margins, a trend that has persisted throughout FY26. Net interest income for the quarter stood at ₹792.06 crores, marking an 8.78% sequential increase from Q2 FY26's ₹728.12 crores, but remaining virtually flat year-on-year with a marginal decline of 0.09%. This stagnation in core income generation capability highlights the challenging operating environment facing mid-sized private sector banks.

Interest earned during the quarter reached ₹2,220.05 crores, growing 1.88% quarter-on-quarter but declining 1.03% year-on-year. The composition revealed that interest on advances contributed ₹1,620.71 crores, down from ₹1,640.79 crores in Q2 FY26, suggesting pressure on lending yields. Income on investments provided ₹422.53 crores, up from ₹406.46 crores sequentially, indicating the bank's treasury operations partially offset the decline in lending income.

On the cost side, interest expended declined to ₹1,427.99 crores from ₹1,451.06 crores in Q2 FY26, a 1.59% sequential reduction that helped cushion the impact on net interest income. However, the year-on-year comparison showed interest costs declining only 1.53% from ₹1,450.24 crores in Q3 FY25, indicating limited success in reducing the cost of funds despite the improving liquidity environment.

Other income, comprising fee-based revenues and treasury gains, contributed ₹302.30 crores in Q3 FY26, down 11.96% from ₹343.37 crores in Q2 FY26 and up 3.40% year-on-year from ₹292.36 crores. The sequential decline in non-interest income added to profitability pressures, though the year-on-year growth provided some comfort. Operating profit before provisions stood at ₹451.80 crores, up 2.67% quarter-on-quarter and 4.33% year-on-year, demonstrating operational resilience despite top-line challenges.

Asset Quality: Steady Improvement Continues

The bright spot in Karnataka Bank's Q3 FY26 performance was the continued improvement in asset quality metrics. Gross non-performing assets stood at 3.32% of advances, marginally better than 3.33% in Q2 FY26 and significantly improved from 3.11% in Q3 FY25. Net NPAs compressed to 1.31%, down from 1.35% sequentially and 1.39% a year ago, demonstrating effective resolution and recovery efforts.

The provision coverage ratio remained robust at above 81% levels seen in recent quarters, providing a strong buffer against potential credit shocks. Provisions and contingencies for the quarter totalled ₹94.86 crores, a substantial increase from ₹20.07 crores in Q2 FY26, though lower than the ₹110.80 crores set aside in Q1 FY26. This elevated provisioning in Q3, despite improving NPA ratios, suggests a conservative approach to credit quality management.

The bank's capital adequacy ratio of 19.94% (total) remained well above regulatory requirements, with Tier 1 capital forming a substantial portion. This strong capital position provides Karnataka Bank with adequate headroom to support business growth whilst maintaining prudent risk buffers. The advance-to-deposit ratio of 72.28% indicates a balanced approach to asset-liability management, leaving room for further credit expansion without straining liquidity.

Profitability Metrics: Return Ratios Under Pressure

Karnataka Bank's return on equity stood at 9.11% as of the latest reporting period, below the banking sector average and significantly trailing better-performing peers. The return on assets of 0.97% similarly reflected the profitability challenges facing the institution. These metrics, whilst remaining positive, indicate that the bank is generating returns below what investors typically expect from well-managed private sector banks.

The five-year net profit compound annual growth rate of 19.74% demonstrates the bank's historical ability to grow earnings, though recent quarterly trends suggest this momentum has slowed considerably. The net interest margin averaging 3.32% over recent periods, though respectable, has been on a declining trajectory that threatens future profitability if not arrested.

Operating profit to assets averaged 4.27%, indicating reasonable operational efficiency, though the cost-to-income ratio averaging 53.70% suggests scope for improvement in expense management. The bank's ability to leverage its operational infrastructure more efficiently will be crucial in defending margins in an increasingly competitive environment.

Peer Comparison: Valuation Discount Reflects Concerns

Karnataka Bank's valuation metrics reveal a significant discount to peer group averages, reflecting market concerns about its growth and profitability trajectory. Trading at a price-to-earnings ratio of 6.81x, the bank commands a substantial discount to peers like Karur Vysya Bank (13.62x) and City Union Bank (16.94x), and an even wider gap to Bandhan Bank (26.68x) and RBL Bank (28.64x).

The price-to-book ratio of 0.62x represents a substantial discount to tangible book value, with Karnataka Bank trading below peers across the board. This valuation gap partly reflects the bank's lower return on equity of 9.11%, which trails Karur Vysya Bank's 17.96% and City Union Bank's 12.64%, though it exceeds troubled peers like Bandhan Bank (4.10%) and RBL Bank (4.17%).

On a positive note, Karnataka Bank offers the highest dividend yield in its peer group at 2.42%, following a ₹5 per share dividend payment with an ex-date of September 16, 2025. This attractive yield provides some compensation for investors willing to hold through the bank's margin recovery phase, though it's worth noting that dividend sustainability depends on maintaining profitability levels.

Valuation Analysis: Attractive Entry Point or Value Trap?

Karnataka Bank's current valuation presents a classic value investing dilemma. At 6.81 times trailing twelve-month earnings and 0.62 times book value, the stock appears statistically cheap compared to both its peer group and its own historical averages. The market capitalisation of ₹7,677 crores positions it as a small-cap bank with potential for re-rating if operational performance improves.

The valuation grade has fluctuated between "Attractive" and "Very Attractive" over the past year, currently rated as "Attractive" after a downgrade from "Very Attractive" on April 9, 2025. This suggests the market has become more cautious about the bank's prospects despite the low absolute valuation multiples, likely reflecting concerns about margin sustainability and earnings growth visibility.

The stock's 52-week range of ₹162.20 to ₹220.35 shows significant volatility, with the current price of ₹203.00 positioned 25.15% above the low and 7.87% below the high. This mid-range positioning suggests the market is in a wait-and-see mode, neither fully pricing in a turnaround nor completely discounting the business.

Shareholding Pattern: Institutional Confidence Waning

The shareholding pattern for Karnataka Bank reveals concerning trends in institutional investor confidence. Foreign institutional investor holdings declined sharply to 11.70% in Q3 FY26 from 14.60% in Q2 FY26, a 2.90 percentage point reduction that represents significant selling pressure. This follows an earlier increase from 12.88% in Q1 FY26 to 15.66% in Q4 FY25, suggesting FIIs have reversed their positive stance on the stock.

Mutual fund holdings showed marginal stability, ticking up to 7.74% from 7.64% quarter-on-quarter, though down from 8.30% in Q4 FY25. Insurance company holdings also declined to 7.94% from 8.33%, continuing a trend that saw them hold 11.18% as recently as Q3 FY25. The combined institutional holding of 27.54%, whilst still substantial, reflects reduced conviction amongst sophisticated investors.

Non-institutional holdings surged to 72.46% from 69.29%, a 3.17 percentage point increase that absorbed the institutional selling. As a bank without promoter holdings, Karnataka Bank's shareholder base is entirely dependent on market participants' assessment of its prospects, making institutional confidence particularly important for stock stability and valuation support.

Stock Performance: Volatile Journey with Long-Term Gains

Karnataka Bank's stock has delivered a mixed performance across different timeframes, reflecting the market's uncertainty about its trajectory. Over the past year, the stock generated a 13.66% return, marginally outperforming the Sensex's 10.35% gain by 3.31 percentage points. However, this underperformed the private sector bank index's 15.76% return by 2.10 percentage points, indicating relative weakness within its sector.

The recent momentum has been positive, with the stock gaining 8.06% over the past month and 14.43% over three months, significantly outperforming the broader market during this period. The six-month return of 17.85% versus the Sensex's 4.45% demonstrates strong recent relative strength, though year-to-date performance shows a marginal 1.12% decline.

The longer-term picture reveals more volatility. Over two years, the stock declined 18.51% whilst the Sensex gained 17.59%, representing a significant 36.10 percentage point underperformance. However, the three-year return of 40.34% and five-year return of 211.11% demonstrate the stock's ability to deliver substantial gains over extended periods, particularly for investors who bought during previous downturns.

The stock's beta of 1.35 indicates higher volatility than the broader market, with a 29.01% annualised volatility compared to the Sensex's 11.52%. This high-beta characteristic means Karnataka Bank tends to amplify market movements in both directions, making it suitable primarily for investors with higher risk tolerance and longer investment horizons.

Technical Outlook: Mildly Bullish Trend Emerges

From a technical perspective, Karnataka Bank's stock trend turned "Mildly Bullish" on February 4, 2026 at ₹198.85, reversing from a "Mildly Bearish" stance. The current price of ₹203.00 trades above all key moving averages, including the 5-day (₹202.44), 20-day (₹188.96), 50-day (₹197.60), 100-day (₹188.77), and 200-day (₹189.31) moving averages, suggesting positive momentum across multiple timeframes.

However, mixed signals from technical indicators warrant caution. The MACD indicator shows "Mildly Bearish" readings on both weekly and monthly charts, whilst Bollinger Bands indicate "Bullish" conditions across timeframes. The On-Balance Volume (OBV) presents a "Mildly Bullish" weekly reading but "Mildly Bearish" monthly signal, reflecting the stock's volatile recent trading pattern.

Delivery volumes have shown interesting patterns, with the trailing one-month average of 11.84 lakh shares representing 48.51% of total volume, up from 42.23% in the previous month. This 37.64% increase in delivery-based trading suggests growing investor conviction, though the single-day delivery percentage of 49.74% on February 10 was actually below the five-day average of 47.68%.

Investment Thesis: Quality Meets Value at a Crossroads

Karnataka Bank's investment case rests on several pillars, each with varying degrees of strength. The bank's "Good" quality grade, maintained since November 2025 after an upgrade from "Average," reflects improved long-term financial performance. The five-year net profit CAGR of 19.74% demonstrates historical earnings growth capability, though recent quarters suggest this momentum has moderated.

The valuation remains "Attractive," with the stock trading at significant discounts to both book value and earnings multiples compared to peers. This valuation support provides a margin of safety for patient investors, particularly given the 2.42% dividend yield that offers income whilst waiting for operational improvements to materialise.

However, the "Flat" financial trend designation for Q3 FY26 highlights the challenge facing the bank. The proprietary scoring system currently assigns Karnataka Bank a 65/100 score with a "HOLD" rating, reflecting the mixed signals across quality, valuation, near-term performance, and technical factors. This score places the stock in the 50-70 range characteristic of hold recommendations.

Key Strengths & Risk Factors

Outlook: What to Watch in Coming Quarters

The coming quarters will be critical for Karnataka Bank as it navigates the challenging operating environment. The Q4 FY26 results, expected in April-May 2026, will provide crucial insights into whether the bank can stabilise margins and restore earnings momentum. Management commentary on deposit mobilisation strategies, lending yield management, and cost optimisation initiatives will be key factors for investors to monitor.

The bank's ability to maintain asset quality whilst growing its loan book will determine whether it can sustain its historical growth trajectory. With the banking sector facing headwinds from slowing economic growth and competitive pressures, Karnataka Bank's execution on operational parameters will be decisive in determining whether the current valuation discount represents an opportunity or reflects justified concerns about future prospects.