Are bank stocks a bad investment during the rising interest rate cycle?

Banks are a bad investment in a rising interest rate cycle — or so goes one of the investing myths. In today’s article, I explain why banks should, in theory, do well in a rising interest rate cycle; how the sector has behaved during past interest rate hike cycles and why I am positive on Indian lending financials for reasons that go beyond the rate cycle.

First, the theory part. In the initial months of a rising rate cycle, the interest rate that banks charge their customers (yield on advances) rises at a faster rate than the bank’s cost of funds. This results in higher spreads for the lenders, thereby translating into higher profits.

The reason why yields rise faster is that a large majority of a bank’s lending is tied to an internal benchmark (MCLR or BPLR) or an external benchmark (like repo). As the market-linked external benchmark rises (or cost of borrowing rises, in the case of the internal benchmark), so do the yields.


The reason the cost of funds is slow to increase is on two accounts. First, customers maintain some balances in their current and savings accounts (CASA), which carry a low rate of interest, and rates are not frequently revised here. Second, customers also maintain fixed deposits, which are locked in at a lower interest rate till they mature.

See the chart below that compares the repo rate to State Bank of India’s net interest margin (NIM). A higher repo rate and higher NIMs coincide.

Source: Spark Capital

The extent to which a particular bank’s NIMs expand depends on several factors — like how large the CASA percentage is, the proportion of fixed versus internal benchmarked versus externally benchmarked advances, the share of retail in fixed deposits, overall pricing power, to name a few. The table below compares these details of a few banks.

Now that we have seen why banks’ profits should rise in a rising interest rate cycle, let us look at the practical part — how banking stocks perform during a rising interest rate cycle.

See the chart below. It is fairly evident that during the initial rounds of interest rate hikes, Bank Nifty has had a stellar run. Towards the end of the rate hike cycle, the higher interest rates start weighing in on demand for credit. This, when coupled with the limited ability of banks to pass on higher costs to end consumers, results in falling profits. But, during the initial round of hikes, the historical evidence is clear.

At this juncture, it is important to differentiate between a Covid-induced crisis and other market corrections. To do that, we must delve into how the market values a bank. I will try and use as few jargons as possible.

In essence, banking is a leverage business. When banks lend Rs 100, they can in theory have a capital of say Rs 15-25 and borrow the rest (from depositors, RBI, other institutions). Let us assume that we are evaluating a bank that has a capital of Rs 20 and has lent Rs 100.

During a crisis like Covid, the markets had no frame of reference on what to expect — how long will the crisis last, how many borrowers will default and so on. In such a crisis, let us assume that only 10% of the loans go bust and banks were unable to recover a single penny. That would imply a loss of Rs 10 on a capital of Rs 20 — i.e., half of the bank’s net worth, created over years of existence, is wiped off in just one crisis.

In real life, that is not how it works. Businesses are supported through various schemes (moratorium, ECLGS, and so on). Banks don’t lose the entire sum (NPA is a smaller percentage) and are able to salvage some value (loss given default is never 100%). But for the sake of simplicity, in the above example, markets are right in getting jittery as one event could wipe out half or more of a bank’s capital.

However, the chart below throws up surprising results. I have compared all historical market corrections to Bank Nifty’s underperformance to Nifty.

During the previous market corrections, Bank Nifty was able to bounce back — leverage is a two-way sword; banks benefit immensely during a good cycle — and eventually wipe off the underperformance. Since Covid, however, the Bank Nifty has continued to lag.

This is interesting because the banking sector has demonstrated considerable resilience in tackling the crisis created by the pandemic. The eventual creation of bad loans was much lower than most banks’ own internal estimates as well.

A large part of the resilience is on account of the progress that took place over the last few years. It started with the asset quality review (AQR) of banks in 2015. Demonetisation followed in 2016, GST was implemented in 2017 and the NBFC (ILFS) crisis transpired in 2018. By the time Covid hit Indian borrowers, industries were already moving to a more organised space and the overall leverage in India (retail and corporate) had materially reduced.

The inability of Bank Nifty to stage a comeback can lastly be attributed to continued FII selling and their over-ownership in that space. But over a longer period, flows follow fundamentals, and not the other way around. Eventually, flows will return, and the strong fundamentals make me positive about the lending financials’ space in India.

(The author, Jigar Mistry is co-founder of Buoyant Capital. Views are his own.)