The Indian banking sector stocks had a wonderful run in the last two to three years due to various reasons. For one, the Securitisation Act was a significant milestone that went a long way in changing the perception of the sector among the investor community.

A booming retail credit market, hike in foreign direct investment limits, strong improvement in the performance and asset quality of public sector banks and possible consolidation in the sector were the other positives that enthused investors to invest in this sector.

If one were to notice, these were fundamental aspects of the banking sector that saw changes and in turn led to higher investor interest in the same. Now let us come back to present times.

Most of the banking stocks are off their highs and the common question is what next for this sector? As far as the fundamentals are concerned, nothing material has changed enough to warrant this kind of sell off.

For one, if one were to look at the core lending operations of the banking sector, we may be in for a higher growth trajectory.

The Reserve Bank of India has indicated that during the last two quarters of FY04, credit to the industrial sector have risen significantly by 32 per cent.

This we believe, signals the start of the investment cycle. One also needs to keep in mind that this growth has been achieved despite corporates increasingly opting for External Commercial Borrowings.

This revival in industrial credit growth, coupled with an already buoyant retail credit segment may mean that credit offtake from scheduled commercial banks may well exceed the 15 per cent growth (including both food and non food credit) that was seen in FY04.

Added to this, the new government has promised higher investments in the rural, industrial and infrastructure sectors. Now, this is only possible if the banking and finance sector plays an active part in disbursing credit.

One must also understand the fact that in the last two to three years, Indian banks, especially public sector banks, have significantly cleaned up their balance sheets and are in a much better position to capitalise on this opportunity.

The Securitisation Act too is not likely to suffer due to the change in the government. As far as the issue of disinvestment and hike in the FDI limits in the banking sector is concerned, we may have suffered a setback.

The process of consolidation may slowdown. While further deregulation may be an eventuality going forward, Indian investors in the meanwhile should not squander the opportunity they have in hand.

Having looked at the fundamentals, there are three aspects that could increase the risk profile of banking stocks.

1. What if interest rates were to go up towards the end of the year? Given the fact that a significant level of housing, cars and durables are financed these days, how is it going to impact the banking sector remains to be seen. Remember, retail credit has been the fastest growing segment in the last 3 to 4 years.
   
2. One of the key reasons the banking sector, per se, was able to clean up their balance sheet in the last four years was higher treasury income (thanks to the decline in interest rates). While banks do have large unbooked profits, there could be some effect on earnings in the medium-term, if interest rates were to increase. UTI Bank, in its analyst meet, indicated that the profits from sale of investment would be lower by 50 per cent in FY05.
   
3. A number of smaller banking stocks have also significant rise in prices in the stock markets in the last three years. Whether these banks have the ability to cope up with any uncertainties remains to be seen. To that extent, a retail investor has to be cautious.

Overall, from a three- to five-year perspective, prospects of the Indian economy and consequently the banking sector are promising. But we would conclude by saying that the banking sector, in the process of growth, need to fulfill their roles with utmost integrity.

Since banks deal with cash, there have been cases of mismanagement and greed in the past (both globally and in India).

And hence, in the final analysis, investors need to check up on the quality of management. This is the last factor but not the least to be brushed aside.

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