Banking stocks: What next?

Mon, 20 Sep Pre-Open

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Indian markets maintained their winning streak, as they emerged the best performers among key global markets last week. This was the second straight week of outperformance by India. The Sensex closed with gains of 4.2%, though matched by Japanese markets that closed with similar gains. Within India, stocks from the banking and oil & gas pack performed the best. While the BSE-Bankex gained 5.9% during the week, the BSE-Oil & Gas was up 5.5%.

Source: BSE

Let's talk about banking stocks here. This week's gains in these stocks were largely driven by the announcement of ‘less stringent than feared' new capital adequacy norms as agreed by global banking regulators. The Basel Committee on Banking Supervision, representing regulators from 27 nations, has more than trebled its capital requirements for banks. But what has cheered investors in bank stocks is that the committee has given banks a long eight years (January 2019) to comply in full to these (Basel-III) norms.

These measures are part of the committee's efforts to prevent future financial crises. What this extension of compliance timing will do is let the banks do away with the need to raise fresh capital. And it would also be valid for Indian banks. But what now remains to be seen is whether global banks take some cues from this extension and try and repair their balance sheets rather than creating another financing bubble.

The last week also saw the RBI announcing its review for the monetary policy for 2010-11. And as anticipated, the central bank raised key interest rates. But what was interesting to note was that bank stocks gained after the RBI's announcement. Generally, when the central bank announces a rate hike, banking stock take a hit as higher rates are expected to weaken demand for home and auto loans. Also, higher interest rates push up yields thus eroding the value of banks' bond portfolio, and forcing them to book mark-to-market losses.

Considering these aspects, the rise in banking stocks despite RBI's rate hike announcement came as an interesting observation. One reason for this could be that banks are hoping that the RBI is done with its rate hike policy and will maintain a neutral stance going forward. But this is just a probability, and not a certainty. After all, high inflation continues to rule the roost. And increase credit offtake, which is expected by most economists, is only going to add fuel to this fire.

However, what looks certain is that valuations of banking stocks do not have much headroom to go up from here on. At least the fundamentals do not justify the same. With little upside in margins, banks are expected to rely heavily on their fee income generating abilities in addition to their operating leverage. Also, most banks envisage higher loan restructuring and provisioning costs in the next fiscal, which may eat into their profits. So, buyers of banking stocks need to be very careful about the choices they make.