Asset quality cycle of banks to improve, says Moody's

Stable system outlook driven by five factors, including operating environment and government support

Moody’s said on Monday the banking system would soon move past the worst point of its asset quality down-cycle, supporting a stable outlook for the sector over 12-18 months.

The stock of impaired loans might still increase during the horizon of this outlook. Yet the pace of new impaired loan formation should be lower than what it has been over the last few years, said Srikanth Vadlamani, vice-president and senior credit officer at Moody’s.

The performance of India’s state-owned and private banks continued to diverge. State-owned banks would require significant capital over the next three years, with access to capital markets being limited. Their private sector counterparts would benefit from solid capitalisation and good profitability, he said.

The stable outlook is based on Moody's assessment of five drivers — operating environment (stable); asset risk and capital (stable); funding and liquidity (stable); profitability (stable); and government support (stable).

The operating environment for Indian banks is supported by a stabilising economy. Moody's baseline scenario assumes headline gross domestic product (GDP) growth of 7.4 per cent over the next two years, compared with 7.3 per cent in 2015. Key drivers are favourable monsoon season, ongoing public investment, and continued growth in foreign direct investment.

Asset quality would remain a negative driver of the credit profiles of most rated Indian banks. But the pace of deterioration should slow, according to report.

Aside from legacy issues for some banks, the underlying asset trend for banks would be stable because of the generally supportive operating environment.

Capital levels are a key credit weakness for state-owned banks.  The announced capital infusion plans of the government fall short of the amount required for full capitalisation. However, Moody's said a potential way to bridge this capital shortfall would be to slow loan growth to the low single digits over three years.

Funding and liquidity are bright spots, and remain supported by Moody's expectation of relatively subdued loan growth during the outlook.

Profitability for the banks will reflect stabilising net interest margins (NIMs) and credit costs. Moody's said it expected limited policy rate cuts over the next 12 months, which should help stabilise NIMs. Credit costs will remain high for the sector, but no higher than in recent years for the industry.

State-owned banks would get a high level of systemic support, irrespective of their size. Recent government allocations, wherein weak smaller banks received a disproportionately higher share of capital, supported this view, Moody’s added.