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State Bank of IndiaReuters

Ratings agency Fitch said it expects Indian banks to require over $200bn over the next five years as Basel III minimum capital requirements approach their full implementation.

Indian banks' capital needs will rise significantly – close to 90% of which will be required through core equity and Additional Tier 1 (AT1) debt capital instruments.

State-owned banks, which require close to 85% of the total capital requirement, are at the core of the problem, Fitch said.

Indian banks' average core capital position is weaker than for most Asian banking systems and is burdened by high level of stressed assets and weaker earnings.

"Weak profitability has hurt internal capital generation, while low valuations have precluded access to equity markets and increased the dependence on state support for capital."

More recent buoyant equity markets have opened the door for a few state banks, which are expected to lead the recovery, though investor appetite remains weak. Asset quality should offer some respite as trends are expected to improve in 2015.

But AT1 issuance will be required to meet the capital deficit until a meaningful recovery in equity market valuations takes place.

AT1 constitutes the largest share of the capital requirement. Issuance thus far has been limited to the local market, where investor appetite for such loss-absorbing instruments is largely untested.

What to Watch Out For

Many banks have announced plans to raise common equity via qualified institutional placements. Timelines are tentative, but this is likely to be an important source of new equity that could account for around 40% of the total need.

Recent Reserve Bank of India amendments to Basel III capital guidelines are more creditor-friendly.

By also allowing retail investor participation to widen the investor base to support the potential supply, the RBI may have introduced a level of moral hazard risk – and as a result be forced to bail out investors should there be a need to impose losses.