A recent report by Kotak Institutional Equitie signals a notable shift in the valuation landscape of Indian banking stocks, with large private sector lenders now trading at more reasonable levels after a period of de-rating. This comes at a time when public sector banks (PSU banks), which have led market performance over the past few years, are now trading slightly above their historical valuation bands.

The narrowing gap between private and PSU bank valuations marks a structural shift not seen since around FY2010. Traditionally, private banks commanded a significant premium owing to superior asset quality, stronger return ratios, and better liability franchises. However, recent market movements suggest that this premium has compressed considerably, reflecting both a re-rating of PSU banks and a moderation in investor expectations from private lenders.

Despite the apparent valuation comfort in large private banks, the brokerage highlights that fundamental growth concerns remain unresolved. Industry-leading metrics such as return on assets and loan growth acceleration are yet to show a decisive recovery. This suggests that while valuations may appear optically attractive, the earnings trajectory does not yet fully support a strong re-rating.

Kotak Institutional Equities maintains a preference for large private banks including Axis Bank, HDFC Bank, and ICICI Bank. However, it tempers expectations by indicating that returns across these lenders are likely to be broadly similar, implying limited scope for sharp alpha generation in the near term.

Within the mid- and small-cap banking space, the brokerage expresses a relatively constructive view on Bandhan Bank, DCB Bank, Equitas Small Finance Bank, and Ujjivan Small Finance Bank, where specific business models and niche lending segments may offer better growth visibility.

In contrast, the report adopts a cautious stance on regional banks, citing stretched valuations and limited incremental upside. It also flags that PSU banks, including State Bank of India, may struggle to sustain their recent outperformance, particularly as valuation comfort diminishes and competitive pressures intensify.

From an operational standpoint, the broader banking sector continues to witness steady but moderated credit growth, estimated at 12–14 percent year-on-year. This is below long-term averages and reflects a cautious corporate sector, where capital expenditure remains largely funded through internal accruals rather than fresh borrowing.

Within retail and MSME segments, trends remain mixed. MSME lending continues to outpace broader credit growth, supported by improved underwriting practices and increased use of data analytics. On the retail side, housing loan growth has moderated, unsecured lending has slowed after regulatory tightening, while auto loans and gold loans remain relatively resilient.

A key structural shift highlighted in the report is the rising competitive intensity in the sector. PSU banks are increasingly gaining market share in lower-risk and granular retail segments, areas traditionally dominated by private lenders. This has reduced the differentiation that private banks historically enjoyed, particularly in terms of liability franchise strength.

Deposit growth has emerged as a critical constraint for the sector. With deposit mobilisation lagging credit growth, banks are increasingly relying on bulk and institutional deposits. This shift reduces balance sheet granularity and limits flexibility in managing liquidity coverage ratios. Additionally, softer household financial savings have further constrained deposit inflows.

Importantly, PSU banks are no longer losing deposit market share at the pace seen in previous cycles. They are now reporting deposit and CASA growth rates comparable to private banks, effectively eroding the latter’s long-standing advantage in low-cost funding.

This evolving liability dynamic has direct implications for profitability. The report underscores that the current environment is unfavourable for net interest margins (NIMs), particularly for private banks. Rising competition for deposits is pushing up term deposit costs, while PSU banks, operating with lower return thresholds, are less aggressive in passing on higher costs to borrowers. This asymmetry is likely to skew margin risks to the downside for private lenders.