A Closer Look at India's Rich Bank Stocks

The worst is over for India's banks. Stock investors, though, seem to think the best is right around the corner.

Having doubled in the past year, bank shares are already trading well above historic valuations. Certainly earnings are rebounding: ICICI Bank, the country's largest private lender by assets, reported a 35% year-to-year rise in earnings for the quarter ended in March. At rival HDFC Bank, profit rose 33%.

Bloomberg News

ICICI Bank's fiscal earnings rose 35% over the previous year.

There are a few reasons why growth might not hold up as well as investors hope. Beyond the fact that India's central bank has begun raising interest rates and asking banks to reserve more cash, banks are likely to see their cost of funds rise as New Delhi floods India's bond market with new debt issuance to finance its ambitious spending plans.

Banks are key to the government's borrowing, having poured 35% of their deposits into government bonds last year, Macquarie Research says. That's a fine use of funds when demand for new loans is low anyway, but every rupee invested in freshly issued government debt this year is a rupee that can't be lent out to an eager borrower.

It means credit growth this year could be as low as 18%, Macquarie says, below the central bank's forecast for 20% growth, and well below the 30% growth rates seen in India's 2006 to 2008 lending boom—the last time share prices were at current levels.

Meanwhile, as New Delhi's borrowing pushes bond prices lower, it'll also erode earnings from treasury operations—a significant contributor to bank profits. Already in 2010, the yield on benchmark 10-year government bond is up 0.39 percentage point.

Another possible drag on loan growth: Worried by banks' exposure to real estate, the central bank could increase required reserves against such loans. The banks now are benefiting from measures enacted during the crisis that allow them to set aside only 1% of a real-estate loan's value. In 2007 they were setting aside 2%.

Certainly there are some favorable winds. Fee income, from the sale of foreign-exchange hedges, for example, could hold up as companies worry about volatility in exchange rates. At ICICI, this jumped 13% in the March quarter. As asset quality improves and banks work off bad debt that piled up during the crisis, earnings should rise as provisions are unwound.

Current prices, though, are discounting a picture-perfect story. The BSE Bankex, for example, sits above levels seen in most of 2007 and the years prior. Shares of HDFC reached an all-time high Monday.

That, certainly, is more credit than is due.