Kotak Institutional Equities prefers HDFC Bank and ICICI Bank at the prevailing levels, as it feels Axis Bank Ltd needs to demonstrate improved franchise performance relative to peers to justify a premium. Among public sector banks, SBI remains Kotak's preferred exposure.

The brokerage said benign asset quality trends and a supportive funding environment could warrant higher risk-taking, but current valuations appear to adequately reflect the upside. "Valuations remain compelling, despite recent outperformance, with most banks still trading below our fair values. We see scope for multiple expansion alongside steady earnings compounding. Within this context, we maintain a relative overweight stance on frontline private banks," Kotak said.

The domestic brokerage said the sector was at an interesting juncture in the cycle where re‑rating is likely to be driven by yield discipline (public banks) and improved access to lower-cost of borrowings (FNCR deposits). 

Asset quality should remain resilient, it said. This is seen supported by strong retail vintages and stable corporate balance sheets. MSME risks are said to be contained with policy support. 

Kotak said lower slippages from the retail loan portfolio can offset any unexpected surprises that may come through any unexpected stress from the MSME portfolio. Overall, it expects slippages to remain at current levels in the short term, while one has to see how the cycle develop to have a medium-term view on asset quality ratios.

"Valuations remain attractive despite recent outperformance, with scope for multiple expansion and earnings compounding. We have a relative preference for frontline private banks alongside SBI among public sector lenders," Kotak said.

Kotak said a recovery in net interest income (NII) growth and stability in slippages are likely to be the two key drivers to rerate the sector. 

"We have seen earnings being corrected lower to reflect the pressure on NII rather than any deterioration in asset quality metrics. Within NII, we see the pressure emerging from the slower growth in deposits resulting in higher cost of borrowings leading to slower NII growth. Loan growth is still ahead of our current expectations. still ahead of our current expectations," it said.