In the second half of June, they poured ₹14,634 crore into financial services. By the fortnight ended September 15, they were net sellers to the tune of ₹6,204 crore—the sharpest selloff across all sectors. This represents a swing of over ₹20,800 crore in positioning in less than three months. The reversal isn't isolated to financials. FIIs were net sellers across 13 of 24 sectors, dumping automobiles (₹2,670 crore), oil and gas (₹2,385 crore), and FMCG (₹2,029 crore). This breadth of selling indicates a systematic reduction in India exposure rather than a sector-specific bet, driven by global macro headwinds like rising US bond yields, geopolitical tensions, and a stronger dollar.
However, the selling in financials has specific triggers. The Reserve Bank of India flagged persistent bank margin stress in June 2026, with Net Interest Margins falling to 3.21% from 3.26% a year earlier. High deposit costs, credit growth outpacing deposit accretion, and FCNR(B) liabilities are compressing profitability. Additionally, the RBI's liquidity management operations, including a ₹7 lakh crore reverse repo auction, have raised concerns about excess liquidity suppressing yields. While sectors like healthcare (₹2,114 crore inflows) and construction (₹930 crore) attracted money due to their defensive or infrastructure-linked characteristics, banks face direct exposure to RBI policy uncertainty and rupee stability, making them the most practical exit for foreign investors reducing India exposure.
Despite this foreign exodus, domestic Chief Investment Officers see a compelling opportunity. They argue that current valuations are disconnected from underlying business performance. Indian banks have delivered significant fundamental improvement. Return on Assets has strengthened, with SBI's ROA climbing from 0.67% in FY22 to 1.12% in FY26. Return on Equity has shown similar resilience, with SBI's ROE improving from 13.92% to 18.57% over the same period. PSU banks achieved record net profits of ₹1.98 lakh crore in FY26, with gross NPAs falling to 1.93%—levels matching private sector peers. Loan growth remains robust, projected at 11.0-11.7% for FY27. These metrics suggest the businesses are performing well even as stocks have become cheaper since the previous quarter.
The valuation gap appears unsustainable. Indian banks have underperformed global peers by 35-100% over the past two years despite trading at lower P/E multiples and PEG ratios relative to their growth expectations. Their ROE levels of 14-18% are comparable to stronger emerging-market banks, yet they trade at significant discounts. Rishi Kohli, CIO at JioBlackRock Mutual Fund, notes that this underperformance is difficult to justify given the attractive valuations, specifically in large private banks. The PSU bank re-rating trade, which saw the Nifty PSU Bank Index gain 26% in 2025, has largely matured. The structural tailwinds—loan market share gains and legacy stressed asset recoveries—have played out, shifting the relative value proposition toward private banks with superior earnings growth potential (projected at 21% CAGR vs 8% for PSU banks).
He points to the RBI's ₹7 lakh crore reverse repo operation attracting limited takers as evidence that excess liquidity isn't suppressing NIMs as feared. If liquidity were truly excessive, banks would park funds with RBI rather than hold them back. Singh argues that short-term rate dips to 2-3% would be temporary rather than structural, given robust credit growth and the RBI's active liquidity management. Key indicators to watch for confirmation include declining VRRR subscription ratios, stabilizing overnight rates converging toward the policy rate, and normalizing FCNR(B) inflows after the window closure.
The investment case is further strengthened by the structural shift in market ownership. FII ownership of Indian equities has fallen to 14.7%, a 14-year low, while DII ownership has reached a record high of 18.9%. Domestic investors, powered by record SIP inflows, have absorbed significant FII outflows, creating a more stable market foundation. This domestic conviction, combined with the valuation disconnect, sets the stage for a potential inflection point.
The implications for the broader market are profound due to the banking sector's enormous weight in benchmark indices. Financial services contribute approximately 33-35% of the Nifty 50 composition. The top four banks alone—HDFC Bank, ICICI Bank, Axis Bank, and Kotak Mahindra Bank—account for nearly 28% of the index. This concentration means that even a modest rotation into large private banks could disproportionately impact Nifty and Sensex performance. A 15% recovery in just these four stocks would contribute over 4% to the Nifty 50, even if all other stocks remained flat.
Large-cap performance has been held back by the dual drag of IT weakness (Nifty IT down 26% YTD) and lack of bank support. A banking recovery would not only provide direct index impact but also trigger broader sentiment improvement, signaling economic confidence and liquidity normalization. As Kohli suggests, if banks and a few other heavyweights start performing, the broader indices should do well. The current setup—exhausted FII selling, strengthening domestic conviction, attractive valuations, and improving fundamentals—creates a compelling risk-reward opportunity. The convergence of these factors suggests that the banking sector could be the catalyst that breaks the two-year large-cap consolidation and triggers the next phase of market outperformance.
