India\u2019s economic and credit slowdown is revealing the strengths and weaknesses of its banking sector. Roiled by unprecedented frauds and surging bad debt, the nation\u2019s state-run banks have returned the least to investors this year. However, investors\u2019 belief in the potential of Asia\u2019s No. 3 economy shows in the fact that its newest lenders offer the best returns, and a clutch of private Indian banks are among the world\u2019s most expensive. For instance, AU Small Finance Bank Ltd.\u2019s return-on-equity, a measure of profitability, was 56 percent compared with about 15 percent for China Construction Bank, 11 percent for JPMorgan Chase & Co. and an average 11.3 percent across 430 global lenders with a market cap of over $2 billion. \u201cIndia\u2019s banks have had a sharply divided run - while consumer banks are riding the crest of consumption and strong and good quality credit demand, wholesale banks are saddled with restructuring challenges of the economy,\u201d said Aditya Narain, an analyst at Edelweiss Securities Ltd. \u201cMore tellingly, credit challenges faced by wholesale banks have led to them becoming significantly risk averse, opening up a very large market for well capitalized and confident retail banks to aggressively make marketshare gains.\u201d Fresh Challengers A decision by former central bank Governor Raghuram Rajan to create new banks for the first time in more than a decade have yielded two fresh lenders that investors are bullish about. Singapore\u2019s state investment firm Temasek Holdings Pte bought about 5 percent of AU Small Finance Bank Ltd. for $147 million this month and Goldman Sachs Group Inc. this month initiated coverage on Bandhan Bank Ltd. with a buy call. There\u2019s also about a year to go for national elections, a period during which the government spends more on the hinterland to win votes. Bandhan is focused on the underbanked regions of eastern India. \u201cThis is a high-yield business,\u201d said Jaikishan Parmar, an analyst at Angel Broking Ltd. \u201cWe expect that Bandhan would continue to grow at a healthy rate and maintain higher net interest margins.\u201d Indian private-sector banks are also among the most richly valued. HDFC Bank Ltd. in January became only the third Indian company whose market cap has crossed the 5 trillion rupee ($73 billion) mark and Goldman sees it hitting $100 billion by 2020. The lender last month reported the strongest fee income in the past eight quarters and retail loans form 70 percent of its total lending. IndusInd Bank Ltd. trimmed its exposure to companies rated BBB and below to less than 38 percent from more than 48 percent a year ago. Kotak Mahindra Bank Ltd. retained its strong credit growth without worsening asset quality. The key risk for Kotak Mahindra stems from continued stress in the economy, which could hit demand for commercial vehicles and construction equipment, according to Edelweiss\u2019s Narain. The same could be said for Kotak\u2019s peers as Goldman\u2019s economists trimmed their growth forecast for India amid concerns that woes in the state-run bank sector are worse than thought. Bad loans across government-controlled banks are more than double total market cap. State Bank of India, the nation\u2019s biggest lender by assets, reported a record $1 billion loss this week for the quarter ended March 31 as provisions surged and rival Punjab National Bank reported India\u2019s largest ever bank loss after a $2 billion fraud came to light. Half of India\u2019s 22 state-run banks with 20 percent of the sector\u2019s total loans are under the regulator\u2019s strict Prompt Corrective Action program. Five more - some 16 percent of advances - could be brought into the framework that restricts lending and expansion, according to Edelweiss. Despite the government\u2019s \u201crecapitalization of public sector banks, they are likely to face challenges to meet the regulatory capital ratios amid mounting credit provisions,\u201d said Karthik Srinivasan, an analyst at ICRA Ltd. The local unit of Moody\u2019s Investors Service estimates lending by India\u2019s overall banking sector will grow about 8 percent in the year through March 2019, even though private banks will expand credit by some 25 percent.