"The lack of capital restricts the ability of India's public sector banks to write down non-performing loans to more accurate levels. Weak profitability and rising capital demands from Basel III implementation will also continue to pressure the capitalisation of many of these banks," Chugh said.
The US-based agency said PSU banks will have to look for alternate sources to increase their capitalisation.
"India's public sector banks face three key challenges in tapping equity capital markets: low equity valuations, overcrowding in the market, and regulations. At the same time, they may find it hard to raise money via the issuance of additional Tier-1 capital instruments because the risk of default on these instruments is rising," S&P Global Ratings credit analyst Deepali Seth-Chhabria said.
S&P expects the government's commitment of support to PSU banks remains in place.
"We think the polarisation of the market in favour of stronger banks will continue as banks clean up their balance sheets and the full requirements of Basel III kick in," it said.
Also, weak PSU banks would continue to lose market share to the better-performing private sector banks and profitable PSU banks, and non-bank finance institutions or domestic debt capital markets, it said.
"We believe public sector banks with lower capitalisation and internal generation of capital could become takeover targets, resulting in consolidation in the banking sector over time," S&P said.