"Return on equity for the sector will struggle and there will be very material divergence in growth of book value per share, which will continue to create divergent stock price performance," the report highlights. What’s interesting is that the investment downgrade undertaken by the brokerage on India’s three largest private banks follows a different rationale in each case.

For HDFC Bank, which has been downgraded from overweight to equal-weight, Morgan Stanley believes that valuations are full and expects the stock to digest the high multiples in the near-term. “Significant earnings surprise appears to be a low probability event. The stock is over-owned by foreign investors, and with better opportunities in Asia, we find it tough to expect the stock to outperform at current levels,” the report adds.

In the case of Axis Bank, which has been downgraded from overweight to equal-weight, the analysts feel the stock is unlikely to do well in the next couple of quarters given the earnings pressure. While the stock remains the preferred pick among the large corporate lenders, Morgan Stanley slashed its earnings forecast by 28 per cent and 13 per cent for FY18 and FY19, respectively, in anticipation of higher credit costs, lower capital gains and lower net interest income.

While lowering the rating for ICICI Bank from equal-weight to underweight, the brokerage reduced its earnings forecast by seven per cent and five per cent for FY18 and FY19, respectively. A quick respite in asset quality appears unlikely for the bank as its credit costs may remain elevated.

With the risk-reward not being favourable for large lenders, Morgan Stanley is shifting its focus to smaller financiers. Stocks such as Federal Bank and M&M Financial Services have been upgraded from underweight to equal-weight, while MCX has been upgraded from equal-weight to overweight. The brokerage remains positive on IndusInd Bank, Kotak Bank and Yes Bank among banks and Bajaj Finance, Bharat Financial, and the Shiram City Union among NBFCs.

As the report is an Asia Pacific Insight, Morgan Stanley also adds that North Asian banks may see a rerating relative to Indian banks in 2018. “Investors looking to invest in value stocks are likely to look to the north Asian banks, rather than Indian corporate lenders, attracted by the north Asians' lower multiple relative to their pre-provisioning operating profit growth potential,” the report points out. So, will Indian banks continue to receive the giant share of foreign money inflows? Time will tell.