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The Banking sector in India has always been one of the most preferred avenues

of employment. In the current decade, this has emerged as a resurgent sector in

the Indian economy. As per the McKinsey report India Banking 2010, the

banking sector index has grown at a compounded annual rate of over 51 per

cent since the year 2001, as compared to a 27 per cent growth in the market

index during the same period. It is projected that the sector has the potential to

account for over 7.7 per cent of GDP with over Rs.7,500 billion in market cap,

and to provide over 1.5 million jobs.

Today, banks have diversified their activities and are getting into new products

and services that include opportunities in credit cards, consumer finance, wealth

management, life and general insurance, investment banking, mutual funds,

pension fund regulation, stock broking services, custodian services, private

equity, etc. Further, most of the leading Indian banks are going global, setting

up offices in foreign countries, by themselves or through their subsidiaries.

Future outlook

Morgan Stanley is even more bullish, putting state-owned banks as its top theme for 2010. Says

the Morgan Stanley report: Rising rates favour Indian banks as they run a maturity mismatch on

their balance sheets (liabilities have a longer maturity). Thus NIMs (net interest margins) will rise;

coupled with acceleration in loan growth (which trails growth in the Index of Industrial Production),

this will help earnings. The stocks of government-owned banks trade at better valuations than

their private sector counterparts and these will also be helped by a declining fiscal deficit, which

will likely cap long-term bond yields, the report said. Rising interest rates help bank spreads as

loans are repriced immediately, but only incremental deposits are repriced at the higher rate.

So which view is correct? Are bank stocks negatively correlated with interest rates or positively

correlated with the economy? Lets look at what happened during the last downturn after the dot-

com bust.

In 2002, when the economy was struggling and the Sensex went up a mere 3.5%, the BSE Bankex

gained a respectable 34.3%. In 2003, with the green shoots of recovery in the economy, the

Bankex again beat the Sensex, moving up 109.4% while the Sensex gained 72.6%.

In 2004, as the recovery strengthened, the Bankex was up 32.1% and the Sensex 12.4%. It was

only in 2005 that the Sensex outperformed the Bankex and that, too, by a small margin. The chart

shows the annual variation in the Sensex and the Bankex.

Interestingly, the Reserve Bank of India started raising its policy rate only in October 2004, which

may account for the underperformance of the Bankex in 2005 and 2006. If, however, we take the

10-year yield on government bonds as the benchmark for interest rates, these started rising by

the middle of 2004.

The common sense view, pointed out by a banking analyst at a foreign stock broking house, is thatbanks should do well in the initial stages of a recovery as long as interest rates remain low, even

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though they may be rising. He also said that the 10-year bond yield has already gone up

substantially this year, from around 5.3% last December to around 7.7% now, but that didnt

prevent bank stocks from rallying.

Nevertheless, there could well be a reaction against bank stocks as the central bank raises its

policy rate or if we have a big fiscal deficit for the 2010-11 budget. That could be the time to buybank stocks.