Banking stocks have been in the limelight since August 28 on news of the merger of State Bank of Saurashtra with State Bank of India. Since the last three trading sessions the BSE Bankex is up 1.51% as compared to the Sensex, which has been up only 1.36%.

The Reserve Bank tightening of external commercial borrowings also augurs well for the sector, as the new norms will definitely divert corporate credit from international to domestic market, thus boosting the banks' profitability.

However, the markets ignored the regulator discomfort with banks setting up intermediary holding company. This move would make it difficult for ICICI Bank and SBI to attract foreign investors in their proposed holding companies, which will own their insurance and asset management companies. In the last one-week, both ICICI Bank and SBI are up 7.65% and 13.71% on the BSE respectively.

So, is it time for investors to add banking to their portfolio?

Gautam Shah, Technical Analyst, JM Financial Services, expects midcap and smallcap banking stocks to outperform. "Banking has been our favorite for a very long time. Every time there has been a correction, we have been looking at opportunities in the banking space to play the recovery. We’ve done the same in the last couple of weeks and barring an ICICI Bank, which has really been an underperformer in the recent banking rally, most frontline stocks have participated. From current levels, you will see the midcap and smallcap banking do well, which was the case 3-4 weeks back. Banking is a sector which one has to aggressively trade into and any decline should be used as a buying opportunity to add largecap and smallcap stocks," he added.