India’s financial stocks are entering a more selective phase, where the strength of a lender’s deposit franchise, underwriting discipline and execution could matter more than whether it is a bank or a non-bank financier.

Preethi R S, fund manager at DSP Mutual Fund, remains constructive on the sector as retail and small-business credit demand stays healthy and corporate lending shows early signs of revival. With about 73% of the DSP Banking & Financial Services Fund invested in lenders, she sees opportunities across private banks, state-owned banks and specialised NBFCs even as the portfolio builds exposure to asset managers, insurers, exchanges and wealth-management companies to capture India’s financialisation.

Edited excerpts from a chat:

Credit growth remains healthy and asset quality broadly benign, but valuations and earnings trajectories vary sharply across lenders. What is your core investment thesis for the BFSI sector over the next two to three years, and what could derail it?

We expect margins to evolve differently across lenders based on evolving asset mix and strength of liability franchise and balance sheet structure amidst a changing interest rate cycle. Rather than taking a uniform view of the sector, we focus on identifying institutions that can sustainably compound earnings through superior execution.

Our outlook remains constructive. Credit demand across retail and SME segments continues to stay healthy, and we are beginning to see early signs of a revival in corporate lending. We expect margins to evolve differently across lenders based on the strength of their liability franchises and the interest-rate environment. Asset quality across the system remains benign, while valuations in several pockets have moderated from their peak levels, creating attractive bottom-up opportunities.

A sharp deterioration in the macro environment could challenge this outlook. Global shocks, weaker employment and wage growth, or rising leverage among households and small businesses could weigh on both credit demand and repayment behaviour. We therefore continue to monitor these risks closely.

Headline asset quality is strong, but concerns remain around microfinance, unsecured consumer loans and certain small-ticket lending segments. Are credit costs close to a cyclical bottom, and where do you see the greatest risk of negative surprises?

We believe the worst of the stress in microfinance and unsecured consumer lending is largely behind us. Bureau data, delinquency trends and company disclosures indicate that portfolio quality has improved meaningfully, while lenders focused on these segments are seeing credit costs normalise.That said, credit cycles are never static. While asset quality across the system remains benign today, consumer cash flows, employment conditions and leverage levels will determine how this cycle evolves. Rather than assume today’s environment will continue indefinitely, we continue to monitor both macro indicators and company-specific underwriting behaviour closely.

Banks account for about 47% of the DSP Banking & Financial Services Fund, while finance companies, insurance, capital-market businesses and fintech make up a significant portion of the remainder. Is this diversification intended to reduce dependence on the banking and interest-rate cycle?

Although banks account for around 47% of the portfolio, lending, including NBFCs, accounts for approximately 73%. Lending remains the largest profit pool within the financial sector and continues to offer attractive opportunities.

The DSP Banking & Financial Services Fund differentiates itself through its structural allocation to non-lending financials. Today, these businesses account for roughly 25% of the portfolio, compared with around 11% in the benchmark.

Over time, we intend to increase our exposure to high-quality franchises across asset management, exchanges, wealth management, insurance and fintech platforms. These businesses typically operate with asset-light, capital-efficient models and rely less on leverage than traditional lenders. They also stand to benefit from India’s long-term financialisation, making them an important source of portfolio diversification and potential alpha.

ICICI Bank and Axis Bank are the fund’s two largest holdings, while HDFC Bank and Kotak Mahindra Bank have comparatively smaller weights. What differentiates your conviction across large private banks — deposit growth, return on assets, credit costs, management execution or valuation?

Our positioning across large private banks reflects a relative allocation decision rather than an absolute call on any one institution.

Leading private banks have built strong deposit franchises, healthy balance sheets and disciplined underwriting practices. Asset quality across the segment also remains supportive. We therefore compare expected earnings growth, return ratios, valuations and management execution before deciding where to allocate capital.

We also monitor management transitions closely, particularly when leadership changes coincide with shifts in strategic priorities or execution. Ultimately, we allocate capital where we see the most attractive combination of growth, returns and valuation on a risk-adjusted basis.

The portfolio also owns PSU banks, small finance banks and regional lenders. What must a smaller or state-owned bank demonstrate before it becomes investable, and how do you price governance, liquidity and concentration risks?

Several PSU and smaller banks have significantly improved profitability over the past five years, with return on assets around 1% and return on equity in the mid-teens. The key question is whether these improvements are cyclical or structural.

We look for banks that demonstrate stronger underwriting, articulate a clear growth strategy, invest consistently in technology and distribution, respond quickly to emerging asset-quality issues, and strengthen organisational processes. We also place significant emphasis on management teams that can execute these priorities effectively. The growing presence of experienced leaders from established institutions has strengthened governance and execution across several banks.

We often initiate positions during periods of market pessimism and increase our exposure as the investment thesis plays out.

Cholamandalam Finance, Shriram Finance and Bajaj Finance are among the fund’s major NBFC positions. With banks competing aggressively for retail borrowers, where do NBFCs still possess a structural advantage, and what warning signs would make you reduce exposure?

Banks and NBFCs serve overlapping markets, but they often compete through different strengths.

Many specialised NBFCs have built decades of expertise across niche customer segments, geographies and underwriting models that remain difficult to replicate. Vehicle financiers, for example, have developed deep capabilities in used vehicles and borrower segments where conventional bank underwriting may be less effective. Similarly, diversified consumer lenders continue to benefit from broader product offerings, faster turnaround times and stronger cross-selling capabilities.

We would reassess our exposure if demand weakens across key end-markets such as vehicles, customer leverage rises sharply, liquidity tightens materially, interest rates rise sharply, or underwriting standards and execution begin to deteriorate.

How are you playing the wealth management and capital market growth cycle in your fund? What are your views as far as valuations are concerned in the wealth management and brokerage stocks?

India’s financialisation remains one of our key long-term investment themes. India remains significantly underpenetrated compared with developed markets. Mutual fund assets account for only around 20% of GDP, while non-lending financial businesses make up a much smaller share of the BFSI ecosystem than they do in mature economies. This creates a long runway for businesses such as asset managers, exchanges, wealth managers, insurers and financial platforms.

These businesses typically operate with asset-light, capital-efficient models and complement traditional lenders within the portfolio. As a result, we maintain an overweight allocation to non-lending financials relative to the benchmark.

Valuations remain an important consideration, particularly in wealth management and brokerage businesses where earnings can be cyclical. However, over the long term, businesses that consistently grow earnings, gain market share and expand their addressable markets can continue to generate attractive shareholder returns, even without meaningful valuation expansion.