Moody's changes outlook on India's banking system to stable from negative

Moody's Investors Service says that it has changed its outlook for India's banking system to stable from negative because of the gradual improvement in the operating environment for Indian banks.

"The stable outlook on India's banking system over the next 12-18 months reflects our expectation that the banks' gradually improving operating environment will result in a slower pace of additions to problem loans, leading to more stable impaired loan ratios," says Srikanth Vadlamani, a Moody's Vice President and Senior Credit Officer.

Vadlamani points out that deteriorating asset quality was the key driver of Moody's negative outlook on India's banking system since November 2011.

"However, the recovery in asset quality will be U-shaped rather than V-shaped, because corporate balance sheets remain highly leveraged," adds Vadlamani.

The stable outlook is based on Moody's assessment of five drivers: Operating Environment (improving); Asset Risk and Capital (stable); Funding and Liquidity (stable); Profitability and Efficiency (stable); and Government Support (stable).

On the operating environment, Moody's expects that India will record GDP growth of around 7.5% in 2015 and 2016. Growth has been supported by low inflation and the gradual implementation of structural reforms. Moody's points out that an accommodative monetary policy should support the growth environment.

As for asset risk and capital, Moody's says that asset quality will stabilize. In particular, while the banks' stock of non-performing loans may continue to rise, the pace of new impaired loan formation in the current financial year ending 31 March 2016 will be lower than the levels seen in the past four years.

Capital levels, however, are low for public-sector (PSU) banks. Such banks exhibit common equity Tier 1 ratios of only 6%-10%, and their coverage of non-performing loans with loan-loss reserves averages 55%.

Moody's notes that the Indian government (Baa3 positive) announced in July 2015 plans to inject INR700 billion into PSU banks over the next four years. This is a clear credit positive, but this amount is still short of the banks' overall capital requirements. Ability to access equity capital markets remains key if the PSU banks have to address their capital shortfall.

By contrast, high capital levels are a credit strength of the private-sector banks that Moody's rates.

As for funding and liquidity, these factors are credit strengths for Indian banks because retail deposits are their primary source of funding. Most banks comply comfortably with required liquidity coverage ratios, even though only part of their holdings of government securities is categorized as high-quality liquid assets.

In relation to government support, Moody's says the Indian government will continue to provide a high level of support to the banks. For the PSU banks in particular, Moody's expects that the government will not make any changes that could suggest the possibility of reduced support to or differentiation among the banks, because doing so could entail significant systemic risks.

Moody's rates 15 banks in India that together account for around 70% of system assets. Four are private-sector banks and the remaining 11 are PSU banks. The PSU banks are majority owned by the government.

The four private-sector banks exhibit an average baseline credit assessment (BCA) of baa3; in line with their supported ratings and India's sovereign rating of Baa3. By contrast, the PSU banks exhibit weaker standalone fundamentals and BCAs as low as b3.

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