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Public sector bank stocks have rallied more than 25 per cent post their stellar Q2 financial results with net profit jumping by 50 per cent.

Union Bank of India stock price is up by 60.8 per cent over the last month among the PSU bank stocks. Bank of India is up by 56.1 per cent during the month while UCO Bank is up by 32.4 per cent.

The Nifty PSU Bank index made a new 52-week high on Friday. The index was up by 21.35 per cent last month.

Amber Pabreja, Founder and CEO of Trendlyne, said the Nifty PSU Bank index has rallied more than 25 per cent after public sector banks delivered strong Q2 results - a sign of investor confidence. Loan growth has jumped by double digits.

"We should keep in mind, however, that interest rates are on the rise, and deposits are growing relatively slowly. This means more expensive loans and lower net interest margin growth in the coming quarters. It will be a riskier environment for the banks," he said.

"Overall, PSU banks will need to keep a close eye on their asset quality, especially as we head into FY24. And investors will have to become more selective with their picks. I expect major banks to stay resilient. State Bank of India (SBI), for example, reported a net NPA ratio of less than 1 per cent (.8 per cent for September 2022 quarter), and its earnings are expected to grow by 33 per cent in FY23 as per Trendlyne's consensus estimates," Pabreja said.

S&P Global Market Intelligence said in a report that Indian banks will gain from tailwind of rising rates as credit growth stays steady.

Rising interest rates will continue to help Indian banks in the rest of the fiscal year ending March 31, 2023, after high credit growth and stronger margins helped propel earnings.

Five of the six biggest banks by assets in India reported an increase in net income for the fiscal second quarter ended September 30, the report said.

Vinod Nair, Head of Research at Geojit Financial Services, said, "The rally of PSBs was triggered by the strong earnings growth announced in Q2 results. It provided a good set of number with high provision coverage and improvements in asset quality. Combined net profit of 12 PSBs is up by 50 per cent on a Y-o-Y basis to Rs 25,685 crore. "

Nair said the upgrade in outlook demanded improvement in valuation. There was a strong arbitrage opportunity due to heavy disparity between the valuation of private and public sector banks. However, due to sharp rally, P/B ratio has increased to 0.9x from 0.5x, narrowing the valuation gaps and limiting the performance on a short to medium-term.

Banks took advantage of the higher interest rate environment to bolster their net interest margins, while previous efforts to reduce their nonperforming assets resulted in lesser loan loss provisions, their recently released earnings reports showed, S&P Global Market Intelligence said.

The second quarter results of private sector, as well as public sector banks, were "picture perfect", said Tusharika Aggarwal, research analyst, Asia-Pacific dividend forecasting at S&P Global Market Intelligence.

"I remain fairly confident in the banks' earnings for rest of the year. The interest rate hikes, although the quantum will decline, would still benefit Indian banks. And because credit growth is increasing, so despite high-interest rates, net interest income will grow," Aggarwal said.

While lending rates have increased on aggregate with growing demand, interest rates offered to depositors have risen more slowly, Aggarwal said, adding that the gap, along with lower credit loss provisions, has resulted in better return on assets for banks.

Ajit Kabi, Banking Analyst at LKP Securities, said, "The outperformance of public banks was evident as the fundamentals are getting stronger. The recapitalisation had improved the capital requirement which led the banks to grow the balance sheet. The credit growth reported was the highest in the decade. The deposit growth was also above the market growth rate. The large public banks (SBI, BoB, Canara Bank) have gained market share."

On the asset quality front, the GNPA/NNPA level reduced significantly with ample provision buffers. The contingent provision for the bank seems adequate and above regulatory requirements against the restructured pool.

The outperformance across yardsticks and inexpensive valuation has driven the rally in recent times. The rally is likely to continue for public banks as their balance sheet is at a sweet spot to grow with minimum asset quality hiccups, Kabi said.

S&P Global Market Intelligence said bank credit growth picked up for both public and private sector banks in the first half of fiscal 2022-2023, according to Reserve Bank of India data released in September.

Private sector banks' credit growth for the fiscal first half came to 20.4 per cent, compared to 13.9 per cent for public sector banks. The central bank expects gross domestic product growth at 7 per cent in the current fiscal year ending March 31, 2023, and to ease to 6.5 per cent in the next fiscal year, dampened by further monetary tightening in the central bank's fight to control inflation.

Manoj Kumar Dalmia, Founder and Director, Proficient Equities, said PSU bank stocks have been in a rally recently pertaining to good quarters and increased credit uptakes due to festive demand. The banks are also poised well, having improved asset quality.

Despite the rally, many PSU banks are available at a reasonable valuation ranging from 0.5-1.0 Price/BV and investors can accumulate them with a long-term perspective. Some PSU banks to look for could be Canara Bank and Union Bank of India.

Sujan Hajra, Chief Economist and Executive Director, Anand Rathi Shares and Stock Brokers, said, "With robust credit growth, improving net interest margin (typical during the early phase of a rate hiking cycle), adequate coverage ratios, and no major signs of asset quality deterioration, we are fundamentally positive on the banking sector.

"However, with the overstretched credit-to-deposit ratio, either the credit growth rate or the net interest margin of the private sector banks are likely to deteriorate. With very significant excess investment in government securities over statutory requirements, public sector banks are better off which explains the recent strong rally."

After a sharp fall in deposit and credit shares to private banks, there are signs that PSUs may get back a part of it. There has been relative improvements in the return ratios as well. Meanwhile, large valuation differences continue. These factors also seem to be driving the rally, he added.

S&P Global Market Intelligence said the key surprise in banks' fiscal second quarter results was a 25-basis-point quarter-over-quarter expansion in NIM. It added, however, that even as this trend is working favourably now, it will increase the procyclical nature of earnings and will be a concern later when rates begin declining.

Most banks reported faster credit growth as they ride on rising demand for loans. However, deposit growth is lagging and may push up funding costs later, Nikita Anand, associate director at S&P Global Ratings, said.

"We note that deposit growth is lagging credit growth, leading to higher loans-to-deposit ratios, which is positive for margins. However, with higher term deposit rates, there is likely to be some movement of funds from savings deposits to terms deposits. This could lead to some rise in cost of funds," Anand said.

Some bank chiefs said they have started looking at ways to keep NIMs intact.

Dinesh Khara, chairman of State Bank of India, said the bank will continue to open more savings bank accounts to attract low-cost funds and offer remunerative rates on term deposits to customers.

"We are very mindful in terms of increasing our interest rates on the term deposits. So, I think, hopefully our effort will be to sustain the NIM," Khara said during the bank's November 5 earnings call.

State Bank of India reported a rise in fiscal second-quarter net profit to Rs 147.52 billion from Rs 88.89 billion, while Bank of Baroda's net profit for the period rose 56.8 per cent year-over-year to Rs 34 billion from Rs 21.68 billion.

Punjab National Bank, however, reported that its net profit for the quarter fell 55.3 per cent to Rs 4.94 billion as the state-run lender increased provisions for nonperforming assets by 30.9 per cent year-over-year to Rs 35.33 billion.