Since the third round of quantitative easing in the US and the flurry of announcements from the Indian government, banking stocks have rallied sharply. The BSE’s Bankex index is the third largest gainer in the past fortnight, comfortably outpacing the Sensex.

There are a couple of reasons for this. Banking stocks were oversold till recently and valuations had become attractive. Investors’ sentiment has been boosted also by the 25 basis points (bps) cut in cash reserve ratio by the central bank. One basis point is one-hundredth of a percentage point.

But the rally may well be tempered as the second-quarter earnings season begins in another fortnight and fundamentals may not catch up with the rise in stock prices.

Central bank data released on Wednesday highlighted the moderation in credit growth. Total advances grew just 0.1% in the second quarter compared with 1.4% in the June quarter.

The slowdown is all the more alarming since typically loan growth is higher in the second quarter because of seasonal factors. As a result, net interest income growth is likely to slow as well. A couple of brokerages that have put out earnings previews expect bank profits to grow at a sedate 14-15% in the second quarter, about half of the 32% year-on-year growth shown by listed banks in June.

Deposit growth, too, was slower at 1% in September compared with 2.2% in the June quarter, the Reserve Bank of India said. But wholesale funding costs have been coming down for sometime now and that could help protect the margins of some banks. On the other hand, though, even non-interest income may not improve much as fee income is likely to remain subdued.

The key overhang on the sector continues to be asset quality. Gross non-performing assets are sitting at a pretty 5% of the systemic loan book and recast loans at another 6%. A Nirmal Bang Securities report points out that the aggregate debt exposure of companies that went in for a loan recast stands at 39,700 crore, about 54% more than a year ago.

Moreover, companies from varied sectors are queuing up at the doors of the corporate debt restructuring cell, as examples of Deccan Chronicle Holdings Ltd and Visa Steel show.

“Incrementally, we believe stress in the infrastructure value chain should begin to be reflected in the current quarter; exposure to several other segments like textiles, iron and steel has not yet provided respite," says a report from Kotak Institutional Equities.

That could prove to be the dampener to this rally.

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