Corrected: Banks, finance firms hit by RBI's rupee defence

(Corrects paragraph 12 to make clear reference is to 3.5 percent)

By Swati Pandey and Archana Narayanan

REUTERS - A week-long selloff in the shares of Indian banks and finance companies turned brutal on Wednesday, as investors braced for the central bank's currency-defending measures to further squeeze funding markets and bank profitability.

Sell-side analysts said they were advising clients to be cautious on private sector banks that rely heavily on market funding, after the central bank unveiled a second set of measures on Tuesday to drain cash from Indian money markets and defuse speculation against the rupee.

The rupee hit its highest in a week, rallying further from record lows as it secured a respite, thanks to the Reserve Bank of India's efforts to push up rates.

Shares of IndusInd Bank and Yes Bank , private sector banks seen as most vulnerable to RBI's measures, were down 8 percent at one point.

Analysts said the banks were vulnerable as the bulk of their lending activities are financed by wholesale deposits, from companies or other banks prone to move their money quickly.

That contrasts with peers such as HDFC Bank and state-owned banks with a massive nationwide presence that lets them access more stable deposits from retail investors.

Bulk or wholesale deposits make up just 22 percent of HDFC Bank's total deposits. But that ratio ranges from 45 percent to 54 percent for Yes Bank, IndusInd Bank and Kotak Mahindra Bank .

More worryingly, nearly three-fourths of Yes Bank's and Kotak's borrowings mature in less than a year, according to a Credit Suisse report.

Brokers also turned bearish on non-bank financial companies (NBFCs), which traditionally tap short-term debt markets.

"Wholesale funded banks (Yes, Indus, Kotak) and NBFCs are going to be worst impacted," Credit Suisse said. "Apart from the impact on funding cost and margins, growth is now likely to be much lower than the earlier growth trajectory."

Yes Bank Chief Executive and Managing Director Rana Kapoor downplayed his bank's exposure to the money markets. "There could be a small impact on margin," he told reporters, adding that the impact on the bank would not be serious.

THREE-WAY HIT

Analysts estimate the average net interest margin for Indian banks at about 3.5 percent.

Ten-year government bond yields are already up 100 basis points since the RBI pushed up money market rates on July 15. With no indication how long the policy tightening will continue, banks are not talking of raising loan rates.

A second hit to bottomlines of banks and mutual funds would come through a sharp fall in the value of bond portfolios as yields rise. Finally, if short-term rates stay higher for longer, demand for loans could decline and defaults could rise.

Short-term debt markets have dried up, particularly issues of commercial paper with tenors of up to a year, used frequently by finance firms. Yields on these have surged 200 basis points.

"We appreciate the RBI's standpoint, but the way they have jolted the market with a sudden shock is not good for us," said Bhushan Tinekar, the head of treasury at Tata Motor Finance.

Another firm, Reliance Capital, raised 3-month money at 10.35 percent this week, up from less than 9 percent earlier.

The 12-share NSE bank index has fallen 9 percent since July 15, while the broader Nifty has fallen less than a percent.

(Reporting by Swati Pandey in MUMBAI; Editing by Clarence Fernandez)