* Banks report strong growth in interest income
* NPA levels not as bad as expected - analyst
* Savings rate deregulation may hit bigger banks more
* Banking stocks jump, bucks broader market trend (Adds results from more banks, details, quotes)
By Anurag Kotoky and Aniruddha Basu
NEW DELHI/MUMBAI, Oct 31 (Reuters) - India's mid-sized lenders posted strong quarterly profits on Monday, mostly exceeding street estimates, providing a much-needed relief to the stocks which have taken a sharp hit recently on asset quality concerns.
The BSE Banking index closed up 0.72 percent on a day when as many as 13 state-run banks reported financial results for July-September, outperforming the broader market which fell 0.56 percent.
Top private sector lender ICICI Bank also beat street estimates on Monday with a 21.6 percent rise in second-quarter profit, led by higher income from interest and investments and lower provisions for bad loans.
"Earnings of ICICI Bank, Bank of Baroda , Vijaya Bank and Canara Bank have come in higher than expectations and are having a rub off on entire banking pack," said Vijay Mahajan, head of research at Aditya Birla Money.
Top state-run lender State Bank of India (SBI) is expected to report financial results later this month, while the second largest Punjab National Bank reports on Tuesday.
Indian banking stocks faced flak from investors last week when Union Bank of India posted a sharp rise in bad loans, bringing in fresh fears of declining asset quality at state-run lenders.
This followed a credit rating downgrade of SBI by Moody's earlier this month, which had brought the broader market down by 1.8 percent, keeping nervous investors at bay from banks.
"PSU (public sector utility) mid-cap banking has been battered badly in the past 1-2 years, thanks to the fears of NPAs, fear of slowdown etc," said Jagannadham Thunuguntla, head of research at New Delhi-based SMC Global Securities.
"But today what has happened is, the quarterly results that are coming out are not as bad as originally feared. NPA ratios have gone up, but not as much as feared," he said.
Bankers said controlling non-performing assets is their key focus.
"NPAs are the biggest challenge for banks. Because of higher interest rates, defaults have been higher and cash flows have shrunk for companies," said Ajai Kumar, Chairman of Corporation Bank .
The bank aims to bring down its gross NPA ratio to below 1 percent for the fiscal year ending in March, 2012 from a current level of 1.32 percent, Kumar told reporters in Mumbai.
Investors however gave no respite to banks like Oriental Bank of Commerce (OBC) , which said net NPAs ratio rose sharply to 1.90 percent, compared with just 0.70 percent in the year-ago quarter.
Shares of OBC, which also reported a 54.4 percent jump in provision for bad loans and write offs, slumped 5 percent to 289.85 rupees.
In contrast, Dena Bank , which managed to bring down its NPA ratio by 34 basis points to 1.15 percent for the September quarter, got investor cheers and rose 6 percent.
"There are some concerns that whenever there is a downturn in the economy, it will have an impact on the quality of assets. But this is temporary, and banks have strategies in place to address these concerns," said D.L. Rawal, chairman of Dena Bank.
SAVINGS RATE DEREGULATION TO HURT BIGGIES
India's central bank last Tuesday deregulated savings deposit rates, its last administered bank rate, in a move that will expose such accounts to policy rates changes and push up the cost of funds for banks, sending shares in the industry lower.
Mid-sized state-run banks such as Dena and Corporation Bank also said they will take a call on raising saving bank interest rates in the next two or three months, but would prefer to let the bigger lenders make the first move.
"We have enough liquidity, and no compulsion to have a rate increase. But in two or three months, we will have to take a call," Dena Bank's Rawal said.
Indian banks are also struggling with lower margins, as the Reserve Bank of India has raised policy rates as many as 13 times in 18 months to combat stubborn inflation, worsening demand for loans.
Many smaller private banks are expected to benefit from savings rate deregulation, with Kotak Mahindra Bank , IndusInd Bank and YES Bank already raising their rates to as high as 6 percent from the earlier mandated 4 percent.
Smaller and newer banks are seen as potential beneficiaries of the move, as they are now free to offer higher rates in order to attract deposits. (Additional reporting by Abhishek Vishnoi in Mumbai; Editing by Subhadip Sircar)
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