Interest Rate Sensitivity of Banking Stock Returns in India

Besides market risk, banking stocks are also subject to interest rate risk due to the simple fact that banking profitability is a function of prevailing interest rate. This paper examines the effects of interest rate changes on banking stock returns in India using the multivariate OLS and GARCH estimation models over the period 1st April 1996-31st March 2011. The sample consists of 18 commercial bank stocks comprising BANKEX listed on Bombay stock exchange. We find a negative but weak relationship between Bank stock returns and interest rate changes in India. As expected banking stock returns exhibit significant positive relationship with market returns. However interest rate volatility is found to affect significantly the stock volatility in case of most of the banks in India. Hence although interest rate movements may not significantly affect banking stock returns in India but stock's volatility is significantly affected by the interest rate volatility. These results have important implications for policy regulators, bank managers and investing community at large. The investing community should refrain from investing in banking stocks in times of high interest rate volatility. The bank managers may adopt policies and strategies so as to lower the impact of interest rate volatility on stock return. The policy regulators need to ensure that interest rate volatility does not get transmitted into banking stock returns for the stability of financial system in India