Despite the increase in interest rates, the price to book value multiples of these banks have actually moved up.

Of the 16 private banks looked at, as many as 12 show that their price to book value has risen despite an interest rate hike. Do not term this madness — of course there is a method to this.

The primary reason behind this phenomenon is the fact that private sector banks have been able to gradually increase their fee incomes, which are returns on equity (ROE) enhancers. They are unlike net interest income, which can be generated only with the infusion of additional capital or incremental deposits.

Says Sarika Purohit, banking analyst with Angel Broking: “Additional capital means dilution of ROE.”

Even the price to book value is a function of ROE. For, ROE comprises net interest margin and fee incomes less operating expenses and provisions. In the case of private sector banks, ROE is high since fee incomes have been moving up.

Says the banking analyst of Edelweiss Securities: “This is unlike increases in net margins which are the result of higher advances and higher yields on existing advances, which are difficult to achieve.”

The ideal option thus for banks is to progressively increase their fee incomes. Since fee incomes are easy means of enhancing ROE, banks should resort to it. They have to just cross sell their products, leverage technology and implement core banking solutions.

Most private banks have been able to do this successfully and hence their multiples have risen, despite the rise in interest rates.

Not just that, public sector banks have huge investment books with a substantial portion locked up in government bonds and securities. The rise in interest rates mean fall in the value of government securities. Thus, these banks have to take a hit in their investment books when interest rates rise. “That is not the case with private sector banks whose investments in government bonds and securities are not that high,” says banking analyst Rajesh Malani of Prabhudas Lilladher.

There are other reasons that have changed the market perception about private banks and have led to the expansion of the valuation multiple. One, as we inch closer to 2009, the chances of deregulation of the banking sector increase.

That is when you are going to see more foreign banks coming in and increased merger and acquisitions among private sector banks. Says the Edelweiss banking analyst: “Only private sector banks will be able to reap the benefits of deregulation fully.”

Two, private sector banks can post very handsome growth rates since their bases are low. Their balance sheet sizes, profits base and advances portfolio are all small compared with public sector banks. That means on a smaller denominator, they can register impressive growth rates.

What does this mean for investors in banking stocks? Investors need to understand that high interest rates are not all that bad.

Particularly, if the bank in question has the pricing power and is thus able to pass on interest hikes to borrowers. Says an analyst with SSKI Securities: “In that case, the bank continues to make money and maintain its margins. Why, it can even improve its net interest margin in that case.” Most private sector banks have that power.

The message is direct and simple. As an investor, you can go in for private banking stocks which were depressed for a long time. As these banks get into a fast growth trajectory with gusto and trigger off consolidation sooner or later, there is no reason why you should not go in for private banking stocks, notwithstanding the rise in their valuation multiples.