The Indian banking system is undergoing a big transformation lately. The talks of a bad bank have raised hopes that India might finally come out of the vicious circle of Non-Performing Assets (NPAs). Moreover, the government’s objective to make India a USD 5 trillion economy is also expected to provide the impetus to the capex cycle. This leaves India’s banking and financial services sector<\/strong> in a sweet spot with the potential fall in NPAs and resumption of credit growth.<\/p>\n\n\n\n

This brings us to the question: Should you invest in the best performing banking and financial services sector funds to capitalize on this opportunity?<\/em><\/p>\n\n\n\n

First, let’ see how big the opportunity is…<\/p>\n\n\n\n

The proposed National Asset Reconstruction Company Limited (NARCL)<\/a> may help the Indian economy reboot its banking system. The NARCL would enable banks to free up capital, boost profits and raise further capital to strengthen their financial position.<\/p>\n\n\n\n

The NARCL is also expected to resolve the existing bad assets worth Rs 2 lakh crore, which are in excess of Rs 500 crore each. In phase I, NARCL is expected to mop up Rs 90,000 crore of fully-provisioned bad debts and in the subsequent phase, banks can transfer even the assets with lower provisions. This, in turn, may infuse at least Rs 30,000 crore in the banking system.<\/p>\n\n\n\n

The NARCL will do nearly 85% acquisitions against Security Receipts (SRs). Any rigorous recovery on this component may give further upside to the overall collections of the banks. The government has provided a 5-year guarantee of Rs 30,600 crore.<\/p>\n\n\n\n

However, Finance Minister Ms Nirmala Sitharam, while addressing the 74th Annual General Meeting of the Indian Banking Association (IBA), recently clarified that the NARCL is not a “bad bank” as in the case in the United States, because it is purely bank driven. She further added saying, “The government will closely work together with IBA and they would be able to restructure and sell the NPAs<\/em>. In other words, the Indian Debt Resolution Company Ltd. (IDRCL) would serve as the assessment management company for the NARCL.<\/p>\n\n\n\n

It’s noteworthy that the quality of banking assets, especially amongst the large corporate segment, has not deteriorated further in the recent past despite the two waves of the COVID-19 pandemic<\/a>. The delinquencies have mainly come from the retail and Micro, Small, and Medium Enterprises (MSMEs), which have been impacted the most amid the pandemic.<\/p>\n\n\n\n

Nevertheless, as the economy has started opening up, the collections as reported by some of the biggest retail and housing finance companies lenders have started picking up. India Ratings has forecasted a stable outlook for Indian banks in FY22 with an estimation of 8.9% credit growth in the current fiscal.<\/p>\n\n\n\n

As you might be aware, financials have underperformed leading market indices on a Year-to-Date (YTD) basis. As depicted by the graph below an investment of Rs 10,000 each in Nifty 50 and Nifty Financial Services would have fetched 27.7% and 22.5% returns, respectively, on a Year-to-Date (YTD) basis.<\/p>\n\n\n\n

Although the financial services sector has been a laggard in the present market rally (see graph below), it is expected to catch up fast. Indian banks have managed to raise significant capital during the pandemic, which offers more visibility about the turnaround of the sector post-pandemic.<\/p>\n\n\n\n

Graph: Nifty Financial Services (YTD) v\/s Nifty 50 <\/em><\/strong><\/p>\n\n\n\n

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Data as of September 24, 2021
Base: Rs 10,000
(Source: NSE India, PerosnalFN Research)  <\/p>\n\n\n\n

The weight of financial stocks in Nifty 50 and Nifty 500 is 37.6% and 31.3% respectively as of August 31, 2021. As far as the Nifty Financial Services Index is concerned, obviously, it is extremely skewed. For instance, HDFC Ltd. and HDFC Bank which together account for 10.8% in the Nifty 500 index, comprise 40.6% in the Nifty Financial Services Index. The top 5 holdings of the index make up over 73% of Nifty Financial Services.<\/p>\n\n\n\n

With more non-lending financial services companies getting listed on the exchanges, including the insurance<\/a> companies and brokerage houses, more constituents are getting added to the index. And interestingly, the outperformance of Nifty Financial Services over the Nifty Bank in the past 1 year indicates that a few Non-Banking Financial Companies (NBFCs) and non-lending financial institutions have fared better than the traditional ones. The returns generated by banking and financial services funds further support these findings.<\/p>\n\n\n\n

Table: Performance of Banking and Financial Services Sector Funds<\/em><\/strong><\/p>\n\n\n\n