That the global rating agency Moody’s has been maintaining a “negative” outlook on India’s banking system since November 2011 is hardly surprising.

Just a month ago, in its annual report, Trends and Progress of Banking in India , the Reserve Bank of India (RBI) rightly urged commercial banks to have segment-wise data on their non-performing asset (NPAs) accounts, write-offs, compromise settlements, recoveries and restructured accounts.

This is a timely initiative, as the rating agency, too, considers the loan classification, particularly that pertaining to restructured loans and provisioning practices, as “weak” in its latest outlook.

Moody’s “negative” outlook on Indian banking industry is based on an assessment of 15 public and private sector commercial banks (11 public sector and four private sector) it studied, which together accounted for about 66 per cent of the system’s aggregate assets as of end-March 2012.


Moody’s further held that the deterioration in asset quality over the last three years is likely to persist over the next one- and-a-half years, as a result of a range of factors.

Manufacturers would remain pressured by anaemic demand. The outlook for an export recovery too would remain tepid, despite a more competitive currency.

Several sectors could face rising repayment pressures. These include State power distribution companies and independent power producers without their own fuel supplies; telecom companies that face uncertainty over licence fees; lower demand for 3G services and cancellation of licences; and airline companies that face rising jet fuel costs as well as declining revenues because of fierce competition.

Indian banks are characterised by high single/group borrower exposures, exposing them to event risk. This was seen over the past year, when there were high-profile defaults in the power, airlines and telecom sectors.

In a domestic milieu characterised by slow economic growth, high inflation and interest rates and a weak local currency, Moody’s foresees these factors as leading to a further worsening in asset quality of banks, owing to a spurt in provisioning costs and a decline in profitability.

A high level of loan growth, at about 15 per cent annually, is likely to continue outstripping internal capital generation. Hence, Moody’s expects Indian banks to be “challenged to maintain capitalisation at current levels and some will even need to raise new capital externally”.


Indian banks do not perform particularly well in a scenario of stress-testing. Even without stress, the banks’ capitalisation and loss-absorbing buffers are modest, Moody’s reckons.

Most banks, especially public sector banks, would need to raise additional capital by the end of the period covered by its outlook (12-18 months), although core capital levels of Indian banks (system average of 10 per cent) remain well above the minimum regulatory capital requirements.

This is presumably due to the combined effects of (i) loan growth outstripping internal capital generation (ii) the rise in credit costs as asset quality deteriorates and (iii) the government’s expectation that public sector banks should maintain Tier I capital at 9 per cent and the de facto benchmark, particularly in the context of the impending implementation of Basel III norms.

Basel III capital norms require an increasing share of core equity capital in the total capital composition of banks and a shift away from weaker forms of capital.


Moody’s, however, does not foresee Indian banks facing difficulties in raising capital. Besides, the Indian government remains committed to injecting capital in public sector banks.

Alongside, the private sector banks might maintain sufficiently healthy credit metrics to infuse confidence and raise capital from the market.

The rating agency acclaims the Indian banking industry’s funding profile as its key strength. The system boasts a loan-to-deposit ratio of 79 per cent. The banks do not rely so much on wholesale borrowing, a fact that will work to their advantage in times of trouble.

Yet another advantage is the banks’ large holdings of government securities (at about 21 per cent of total banking assets), that point to ample local currency liquidity cover.

Despite deterioration in India’s balance of payments, Moody’s observes that Indian banks remain only marginally exposed to foreign exchange risks, as their foreign currency assets account for only 4 per cent of total assets.

All these point to the rating agency assuming “a relatively high probability of systemic support”. If needed, Moody’s believes that the Indian government would provide extraordinary support in the form of unsecured loans/and or capital injections to both the public and the rated private banks.

Notwithstanding the explicit sovereign guarantee to the domestic banking industry that “it is too big to fail’ when the chips are down, the fact remains that the rating agency has sounded the bugle of caution to the authorities in general and to the banking industry in particular, that a business-as-usual approach will not do.

That is also the reason why the apex bank has said in its annual banking document that “distress dependencies among banks have risen, warranting closer monitoring”.

How far the RBI cracks the whip to ensure sound financial practices in the coming days will be watched and welcomed.