Monetary policy will soon get tighter and interest rates are expected to start rising. What will that mean for the banking sector? One view is that it will be hurt because banks’ bond portfolios will lose value as interest rates rise and provisions for depreciation of those portfolios will have to be made.

A note by Citigroup, for example, says that investors should sell the sectors which depend on borrowing and banks are included in that list of rate-sensitive sectors.

Bank stocks will start to underperform when the rate cycle reverses. In fact, that’s precisely what has happened, and the Bankex index on the Bombay Stock Exchange has underperformed the benchmark Sensex recently.

Most other brokers, however, are much more positive on banks in 2010. Says a note on a recent investor conference hosted by Enam Securities Ltd: “The greatest growth beneficiary of FY11 would probably be in banking." Merrill Lynch points out that loan growth will increase in the future as capital expenditure picks up. Banks will also benefit from the repricing of high-cost deposits.

Graphic: Yogesh Kumar / Mint

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? Let’s 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 that banks should do well in the initial stages of a recovery as long as interest rates remain low, even 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 didn’t 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 buy bank stocks.

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