Banks are lending more, yet financial stocks are trading at a 5-year valuation low—here's why

India's banking sector appears to be doing many of the things investors typically reward. Credit growth is showing signs of improvement, asset quality remains benign, and large private lenders have continued to report healthy balance sheets despite a challenging interest-rate environment. Yet the market is sending a different signal.

The Nifty Financial Services Index is currently trading at its lowest one-year forward price-to-book valuation in five years, even as loan growth gathers pace—a disconnect that YES Securities believes could present a compelling opportunity for long-term investors.

The brokerage argues that the divergence between improving fundamentals and compressed valuations has created an unusual setup for the sector. While investors have gravitated towards pockets such as real estate, capital goods and healthcare over the past year, financial stocks have struggled to command premium valuations despite remaining central to India's economic growth story.

A valuation gap despite improving fundamentals

Historically, accelerating credit growth has supported higher valuations for banks and non-banking financial companies as stronger loan books translate into better earnings visibility. This time, however, investors have remained cautious.

The sector has spent much of the past two years grappling with concerns around margin compression as banks competed aggressively for deposits, pushing up funding costs and squeezing net interest margins. Moderating loan growth, elevated deposit rates and uncertainty over the Reserve Bank of India's interest-rate trajectory also weighed on investor sentiment.

Those concerns are now beginning to ease.

Credit growth has started improving, while analyst confidence in the sector has strengthened steadily. YES Securities notes that banks are among the sectors witnessing rising analyst conviction, alongside automobiles, even as overall sentiment towards large-cap stocks remains constructive.

The brokerage highlighted that "credit growth is improving, but Nifty Financials trade at a five-year valuation low," pointing to what it sees as an anomaly in current market pricing.

Investors are quietly rotating back

Fund flows suggest institutional investors may already be positioning for a recovery.

YES Securities' analysis shows domestic mutual funds increased exposure to large-cap financial names, including HDFC Bank and Bajaj Finance, while trimming holdings in sectors such as commodities and heavyweight stocks like Reliance Industries.

The report also points to improving analyst optimism across the broader market, with large-cap companies continuing to attract the highest conviction because of resilient earnings, stronger balance sheets and relatively reasonable valuations. Financial services remain among the preferred sectoral bets.

The valuation gap does not necessarily imply an immediate re-rating.

Banks continue to face pressure from deposit competition, while net interest margins could remain under strain if funding costs stay elevated. Investors are also watching whether the recent improvement in credit demand proves sustainable amid global uncertainties and evolving trade dynamics.

That makes valuations alone an insufficient catalyst. Instead, a sustained recovery in loan growth, stable margins and continued earnings resilience will likely determine whether investors begin assigning higher multiples to the sector.

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