In conversation with Preethi RS, Senior Vice President & Fund Manager, DSP Mutual Fund

Banking and financial services stocks have gone through different phases of credit growth, asset-quality improvement and valuation re-rating. Where do you see the sector in its current cycle, and what could drive the next phase of growth?

We think that the Indian banking and financial services sector is at an interesting transition point in its cycle. After a period of moderation, we are beginning to see green shoots in credit growth, particularly on the corporate side, while consumer lending also appears to be recovering after the slowdown witnessed over the last couple of years.

Growth acceleration in the corporate segment is driven by large industries and NBFCs, which can be partly explained by bond market substitution. On the consumer side, the regulatory and risk-related tightening of the last two years has resulted in a more calibrated approach to unsecured and retail lending. As this normalises, we should see consumer credit growth recover, albeit on a favourable base.

Importantly, this recovery is happening against a backdrop of benign asset quality. The balance sheets of banks are considerably stronger than they were a decade ago, and provisioning buffers are healthy.

At the same time, valuations across several parts of the financial-services universe have corrected and are at multi-year lows. This creates an attractive starting point because we are not entirely dependent on multiple expansion to generate returns. An improvement in earnings growth, coupled with even a modest normalisation in valuations, can provide a meaningful return opportunity.

The next phase of growth, therefore, could be driven by a combination of credit-cycle recovery, improving corporate credit demand, normalisation in consumer lending and continued benign asset quality. Within BFSI, however, the magnitude and timing of this recovery will differ significantly across businesses, making bottom-up stock selection particularly important.

How significant is the FCNR(B) inflow for Indian banks from a funding perspective? Can it meaningfully ease the pressure created by the gap between credit and deposit growth?

FCNR(B) inflows can be quite meaningful from a system funding perspective, particularly in the current environment where credit growth has been running ahead of deposit growth. Based on current expectations, FCNR(B) deposits could account for around 25 to 30 per cent or more of incremental deposit accretion for the system in FY27, while potentially reaching around 3 to 4 per cent of the outstanding deposit base.

The importance lies not merely in the quantum of deposits, but also in the fact that these provide additional sources of funding for Indian banks and help diversify the liability base. Incremental foreign-currency deposits can provide banks with greater flexibility in managing their overall funding requirements and reduce some of the pressure created when credit growth outpaces domestic deposit growth.

That said, I would view FCNR(B) inflows as an important incremental source of funding rather than a structural replacement for domestic deposits. Banks will continue to compete for retail and institutional deposits, and the sustainability of the credit-deposit growth differential remains an important variable for the sector. Overall, though, in the near term, FCNR(B) inflows can meaningfully ease funding pressures and provide some breathing room for the system as the credit cycle begins to strengthen.

Public-sector banks versus private-sector banks, how do you assess the relative opportunity today? Has the gap in fundamentals narrowed sufficiently to change your preference?

The PSU-versus-private bank debate is much less clear-cut today than it was in the years immediately following the AQR. There has been significant convergence in several operating parameters. In FY26, public-sector banks demonstrated strong growth momentum and outperformed private banks on growth. However, there are still important differences in the quality of earnings and return ratios.

For instance, ROA for a majority of PSU banks remains structurally lower than that of private-sector banks. This is partly compensated by higher leverage, which results in ROEs that are now much more comparable across several PSU and private franchises.

Therefore, I do not think the investment decision can simply be reduced to choosing between PSU and private banks. We look at each bank through the lens of its earnings trajectory, return ratios, balance-sheet strength, competitive positioning, management quality and valuation. Capital is allocated where we believe the risk-adjusted opportunity is most attractive.

For us, this makes a bottom-up approach particularly valuable. It allows us to identify opportunities across both segments rather than having a predetermined preference for either PSU or private banks. Ultimately, what matters is not the ownership structure of a bank but its ability to compound earnings and generate sustainable returns on capital at an attractive valuation.

How do you identify a value trap in the financial-services sector?

Financial services can be particularly prone to value traps because a low valuation by itself does not necessarily indicate that the underlying franchise can recover. One of the things we have observed is that structural turnarounds in financial services are relatively uncommon. If the underlying franchise is fundamentally impaired, changes in management or strategy may not always be sufficient to restore the economics of the business. In such situations, what appears optically cheap can remain cheap for a very long time.

We therefore look beyond valuation and examine whether the business possesses the ingredients for a sustainable turnaround. This includes assessing the strength of the franchise and whether its competitive moat is intact, along with management quality, capital-allocation discipline and execution capability. Importantly, we also assess whether management has both the ability and accountability to deliver the required change.

There are also more tangible financial indicators that help us distinguish a genuine turnaround from a temporary recovery. We focus closely on return metrics and the trajectory of ROA/ROE, rather than simply looking for an improvement from depressed earnings.

For a financial business, our broad hurdle is whether it can sustainably generate returns in the 12 to 15 per cent range or higher, and importantly, how long it takes to get there. A business that demonstrates improving returns but repeatedly fails to cross and sustain its economic hurdle rate may not have undergone a genuine turnaround.

Conversely, if the improvement in return ratios is accompanied by strengthening competitive positioning, better execution and sustainable earnings growth, then the opportunity can be quite attractive. So, for us, the difference between a value play and a value trap is not how cheap the stock looks today, but whether the underlying franchise can sustainably earn its cost of capital and compound from that base.

With the banking and financial services sector being a major component of Indian equity indices, what should investors realistically expect from the sector over the next three to five years?

Over the next three to five years, I would expect BFSI to remain an important contributor to Indian equity-market returns, although investors should have realistic expectations and not extrapolate the strongest periods of the past.

The starting point today is interesting. The sector has underperformed over the last three to five years in several segments, while valuations across parts of the financial-services universe have corrected substantially. At the same time, the fundamental backdrop is beginning to improve, with early signs of a recovery in credit growth and broadly benign asset quality.

This creates the possibility of some mean reversion in both earnings growth and valuations. If credit growth accelerates from current levels while asset quality remains healthy, operating leverage can translate this into stronger earnings growth for financial intermediaries.

I would therefore expect BFSI to have the potential to contribute meaningfully to market outperformance over the medium term. However, I would not expect this to be a uniform sector-wide phenomenon. The dispersion between winners and laggards could remain significant, as businesses differ materially in their growth opportunities, competitive intensity, return ratios, balance-sheet strength and valuations.

For investors, the key is therefore to distinguish between owning the sector and owning the right businesses within the sector. Over a three-to-five-year period, I believe the combination of a healthier credit cycle, stronger balance sheets, improving earnings trajectories and reasonable starting valuations provides a constructive setup for BFSI.

The opportunity, in my view, is less about expecting a broad-based re-rating and more about identifying businesses where earnings can compound strongly from today’s valuation base. That is where stock selection can create meaningful alpha.