Moody's: Outlook for Indian banking system stable

Moody's Investors Service says that its outlook for the Indian banking system is stable, with the system's ongoing progress in managing legacy asset issues offsetting the significant capital shortfalls some banks continue to face.

"The outlook for the system is also in line with the stable outlooks for 10 of the 15 banks we rate in this system and reflects a stable operating environment and improved prospects for asset quality, among other factors," says Srikanth Vadlamani, a Moody's Vice President and Senior Credit Officer.

Moody's conclusions are contained in its just-released "Banking System Outlook -- India, Asset quality at trough levels drives stable outlook". The outlook expresses Moody's expectation of how bank creditworthiness will evolve in the system over the next 12-18 months. The 15 banks rated by Moody's in India together account for about 70% of assets in the system.

"Moody's believes that the operating environment is -- as indicated -- stable. Our baseline scenario assumes GDP growth of 7.1% in the fiscal year ending in March 2018, the same pace as the prior year," says Vadlamani.

While headline growth is robust, private investment remains relatively weak. In the near term, the economy will continue to recover from the temporary liquidity shock from demonetization, while adjusting to the new goods and services tax (GST).

"Indicators, such as net new nonperforming loan (NPL) formation and problem loan ratios, suggest a bottoming of the credit cycle," says Vadlamani. However, deteriorating asset quality in agriculture, and micro, small- and medium-sized enterprise (MSME) portfolios pose risks.

Capitalization will continue to bifurcate public and private sector banks. The common equity Tier 1 (CET1) ratios of public sector banks remain far below those of their private sector peers. The gap is likely to persist due to the government's reluctance to infuse more capital into private sector banks. However, the system's overall loan loss coverage will likely further improve, which, coupled with subdued loan growth, will ease pressure on capitalization.

Profitability remains low, but is improving. Lending margins will be stable because a drop in funding costs following demonetization will likely offset pressure from re-pricing of loans to the marginal cost of lending rate (MCLR). Banks still face higher credit costs due to tighter provisioning requirements for stressed loans, but these charges will be lower in absolute terms. Smaller treasury gains, however, will weigh on profitability.

In addition, banks will continue to have strong funding and liquidity Banks have seen a surge of low cost deposits following demonetization, which has lowered their funding costs. All rated banks will be able to comfortably meet liquidity coverage ratios (LCR) norms.

Government support will remain strong for public sector banks, despite a reluctance to bolster bank capital. The government has maintained support to public sector banks through a range of policies, since failure for any of these banks could pose risks to systemic confidence. To reflect this, we continue to position public sector banks in the "very high" support bucket in our Joint Default Analysis (JDA) model. At the same time, the amount of capital infused by the government in the past four years has not been enough to fully rehabilitate the public sector bank balance sheets. As a result, we have repositioned the number of support notches to the mid-point of notches allowed for banks in the "very high" support bucket.

Of the 15 banks rated by Moody's, four are private sector banks with an average baseline credit assessment (BCA) of ba1, while the other 11 are state-owned entities with weaker standalone fundamentals and BCAs of as low as caa1.