Banking Stocks: Is Recovery In Sight?

Even though there is no negating the fact that banking stocks have dipped due to the underperformance of the sector, they showed signs of a comeback in October, momentarily reversing their underperformance. From the start of October, the banking index has outpaced both the broader and frontline indices. The article takes a closer look at how the banking sector may perform in the coming months and whether investors should continue to place their faith in banks [EasyDNNnews:PaidContentStart]

The ‘Goldilocks’ phase for banking stocks — where banks were benefiting from strong loan demand alongside healthy balance-sheets — seems to have dimmed. This shift is evident in the performance of banking stocks relative to the broader market indices. Year-to-date, the Nifty Bank index has significantly lagged behind the broader market, with Nifty Bank up only 6.7 per cent, while the BSE 500 and Nifty 50 have surged 16 per cent and 11 per cent, respectively. This has led banks, which are index leaders in the 50-stock Nifty, to be off from the peak weight of 32 per cent seen in July 2023 to 27.7 per cent now. The banks’ weight has also come down in the broader NSE 500 by 470 bps from 23.2 per cent to 18.5 per cent in the above mentioned period. 

However, banking stocks showed signs of a comeback in October, momentarily reversing their underperformance. From the start of October, the banking index has outpaced both the broader and frontline indices, posting a smaller decline of 2.7 per cent compared to steeper drops of 6.4 per cent in the Nifty 50 and 6.7 per cent in the BSE 500. This resilience raises the question: Could this recent uptick mark the beginning of a sustained recovery for banking stocks, or is it merely a temporary relief amid broader market volatility? 

Private versus PSU Banks’ Performance
An important development in the banking stock performance has been the strong recovery in public sector banks (PSBs). After the Union General Election results in June 2024, PSBs, that had been market favourites in recent years, began to underperform as an overall theme, including those in the banking sector. From the beginning of the year until early June, the Nifty PSU Bank index gained 29.3 per cent, contrasting with the Nifty Private Bank index, which declined by 3 per cent over the same period. 

However, in the following four months, the momentum shifted. The Nifty PSU Bank index underperformed its private counterparts, declining by nearly 9 per cent, while the Nifty Private Bank index rose by 9.2 per cent. Recently, though, this performance gap has started to narrow. Since late October, PSBs have regained momentum, with the Nifty PSU Bank index up by 7.7 per cent, signalling renewed investor interest and optimism around the sector’s potential for further recovery. 

Overall, it seems that banking stocks, whether private or public, are moving up now. In the sections that follow, we will explore the key factors shaping the outlook for banking stocks. From macroeconomic trends to sector-specific dynamics, we will examine whether banks can regain their footing or if structural challenges could weigh down performance in the longer term. 

Why Banking Stocks Have Underperformed Year-Till-Date 

Liquidity Ratio - The reason for underperformance of the banking stocks is multi-fold. It all started getting reflected in the first quarter results of banks when they saw a serious problem with liquidity. HDFC Bank, the largest private sector lender, saw its share price fall over 4 per cent after the bank reported a sequential decline in advances and deposits in the first quarter. Investors were concerned about its liquidity coverage ratio of 123 per cent in Q1FY25. 

Indian banks are currently facing a complex situation as deposit growth struggles to keep pace with the rapid expansion in credit. This disparity has led to a higher credit-deposit (CD) ratio, suggesting that banks are lending more than they are accumulating in deposits, which could strain liquidity and impair their ability to meet future credit needs. To bridge this gap, banks have increased efforts to attract deposits by offering higher interest rates, a move that, while essential, raises funding costs and pressures net interest margins, thereby impacting profitability. 

Additionally, savers are increasingly diverting funds from traditional deposits into alternative investment avenues like mutual funds and equities, further shrinking the deposit base and heightening liquidity concerns. The Reserve Bank of India (RBI) has expressed caution over the widening gap between credit and deposit growth, warning banks of potential structural liquidity challenges—a stance that may also influence investor sentiment and stir worries about the sector’s stability. Although banks are taking steps to improve this, it may take a few more quarters to bring it to a more sustainable level. 

Asset Quality Concerns - Banks like IndusInd Bank and Kotak Mahindra Bank have reported an increase in bad loans, particularly in the microfinance and credit card sectors. IndusInd Bank’s second-quarter profit declined by 39 per cent due to higher provisions for bad loans, with its gross non-performing assets ratio rising to 2.11 per cent from 2.02 per cent in the previous quarter. Similarly, Kotak Mahindra Bank experienced a 38 per cent increase in slippages, with 30-40 per cent attributed to the credit card business. Overall, we have seen many banks facing concerns about asset quality impacting their share prices. 

Foreign Portfolio Investor (FPI) Outflows - There has been significant selling by FPIs in the banking sector, leading to downward pressure on stock prices. Bank stocks constitute a large portion of FPI holdings, and their recent sell-off has contributed to the sector’s underperformance. 

Competitive Pressures and Regulatory Challenges - The rise of financial technology companies has intensified competition in the lending space, raising concerns about traditional banks’ ability to maintain market share. Additionally, regulatory actions, such as fines and restrictions imposed by the Reserve Bank of India for noncompliance in areas like know-your-customer (KYC) norms, have adversely affected investor sentiment. 

Is the Worst Behind Us? The Indian banking sector is displaying signs of stabilisation, bolstered by supportive regulatory and economic shifts. The RBI’s recent adoption of a ‘neutral’ policy stance indicates a more accommodating monetary environment that could lower funding costs and stimulate credit growth. This policy shift aligns well with India’s solid economic growth outlook, which is expected to persist, providing a favourable environment for banks through greater lending opportunities and improved asset quality. 

Following a 75 basis point (bps) rate cut by the US Federal Reserve, a 50 bps policy rate reduction in India over the next six months appears likely, along with a potential 100 bps easing in the yield curve. These adjustments lay the foundation for bank margin expansion, as easing funding costs and accelerating high-yield, fixed-rate loan disbursements should gradually enhance profitability. The benefits of lower funding costs will unfold over time, driven by the re-pricing of fixed deposits and an increase in CASA (current account savings account) deposits. 

Consequently, we anticipate that robust credit growth will translate into strong earnings momentum for banks in FY26, with mild support from margins as they stabilise beyond the recent headwinds. In FY25E, banks will continue to focus on branch expansion and new product launches to boost deposit momentum. Additionally, to diversify their funding sources and mitigate the lag in deposit growth, banks have increasingly turned to certificates of deposits despite the relatively higher associated costs – a strategy that has gained notable traction in the market. 

The banking sector saw robust credit growth in FY24, consistently outpacing deposit growth throughout the year. Looking ahead, we anticipate that credit growth will moderate to a range of 13-14 per cent, primarily due to a slowdown in unsecured segments like credit cards and personal loans, as well as among non-banking financial companies (NBFCs) impacted by the RBI’s recent increase in risk weights. Meanwhile, housing sector credit is expected to gain momentum, driven by a likely repo rate cut by the central bank this fiscal year and the government’s continued emphasis on affordable housing initiatives. 

This combination should support sustained credit growth within the housing segment, contributing positively to the sector’s overall stability. Hence, we believe that the stock prices will start reflecting these fundamental factors going ahead and the sector may find regain its earlier mojo. Now, let us examine the technical factors and valuations to understand what we can expect from the banking stocks going ahead. 

Nifty to Nifty Bank’s Ratio Chart
In the ratio chart we take two variables and calculate the ratio by dividing them. Plotting this ratio calculated on a continuous basis gives us the ratio chart. For example, dividing Nifty 50 by the Bank Nifty will give us the Nifty50 / Bank Nifty ratio. 

Taking the historical daily closing value of both the indices and plotting the calculated ratio will give us the daily ratio chart of Nifty50 / Bank Nifty. The same done by taking the weekly closing values of both the indices will give us the weekly ratio chart. 

A rising ratio chart indicates that Nifty is outperforming Bank Nifty. On the other hand, if the graph falls, then it means that Nifty is underperforming and Bank Nifty is outperforming. In a ratio chart, the rise and fall in graph will always have to be interpreted with respect to the numerator, Nifty in our case here. Also, the ratio chart will give us only the relative performance of the two parameters that are being used and not the direction of the absolute price movement. That is, a rising ratio chart does not mean that Nifty will rise or vice versa. 

In the chart above, the Nifty / Bank Nifty ratio is currently at 0.468. On the charts, the trend is down. This has come down from 0.49 in the mid of October 2024. The ratio can fall to 0.42 from here in a month or two. In this period, Bank Nifty will outperform Nifty. As we head into year 2025, the ratio chart can extend its rise towards 0.40 in the first quarter next year. Nifty 50 is taking support near the level of 24,000 and looks attractively priced. A rise in Nifty and the outperformance of Bank Nifty may help it to post gains. 

Valuation of Nifty Bank
An analysis of the historical valuation of Bank Nifty reveals that the current levels are not excessively high; rather, they appear attractive. The valuations are slightly lower than the historical averages – they remain within reasonable limits. The current price-to-book value (PBV) ratio for Bank Nifty is 2.31 times, which is below its long-term average, suggesting favourable pricing for investors. 

However, relying solely on PBV can be limiting, as a comprehensive investment view requires multiple valuation metrics. Another key metric, the price-to-earnings (PE) ratio, indicates that Bank Nifty’s trailing 12-month PE is 14.15 times, which remains well below its long-term mean of 20.23 times. 

This further implies that Bank Nifty is attractively valued across several parameters. 

Overall, both PBV and PE ratios highlight that Bank Nifty is reasonably priced, offering a potentially appealing investment opportunity for those considering a balanced approach. 

Conclusion
In conclusion, while the banking sector faces slight increases in slippages within personal loan portfolios and microfinance institutions (MFIs), these remain manageable, with RBI’s concerns focusing more on systemic stability than on individual banks. Public sector banks have significantly strengthened their competitive position alongside private banks, benefiting from increased investments in technology and regulatory support from the RBI. This solid foundation, along with the sector’s stabilising outlook, fuels optimism for continued double-digit growth in line with India’s economic trajectory. 

Despite some constraints on growth, largely due to deposit limitations and rising credit costs in unsecured segments, the banking sector’s attractive valuations add to its investment appeal. Large private banks like ICICI Bank and Axis Bank are well-positioned to leverage these valuations with diversified loan portfolios and substantial provisions, making them strong investment candidates. While Kotak Bank has experienced margin declines and increased slippages, these reflect broader sector trends rather than individual bank weaknesses. 

Public sector banks also offer compelling value, particularly the State Bank of India (SBI), which stands out among the PSUs due to its solid positioning and resilience. Axis Bank, with its robust balance-sheet and growth potential, presents an attractive medium-to-long-term opportunity as sector conditions normalise. With appealing valuation metrics and a cautiously optimistic outlook, the banking sector offers significant growth potential for investors focused on select stocks poised to benefit from medium to longer term perspective.

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