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Moody's has maintained its negative rating for India's banks due to high leverage in the corporate sectorReuters

The Indian banking system is still weak due to its high leverage in the corporate sector that could prevent any meaningful recovery in asset quality over the next 12-18 months, Moody's said, after stating that its outlook on the system remains negative.

"India's broad corporate sector is highly levered, with a debt-to-equity ratio of more than 3.0x. In particular, corporates engaged in infrastructure projects face both structural and cyclical challenges," Moody's said.

The rating agency said the negative outlook on the Indian banking system pertains mainly to the public-sector banks, which represent more than 70% of total banking-system assets.

"These banks have experienced higher growth rates in non-performing and restructured loans, as well as greater weakening in profits, than private-sector banks, and these trends are unlikely to improve for public-sector banks," said Gene Fang, a Moody's vice president.

"Going forward, India's corporate sector will remain highly levered, representing an obstacle to a cyclical recovery in asset quality."

The Moody's report released on Wednesday (29 October) showed that the asset quality and capital strength of Indian banks are deteriorating while operating environment and liquidity are stable.

The profitability and efficiency of the Indian banking system is also deteriorating though the systemic support remains stable, according to the firm.

Growth-Related Challenges

India's economic growth could pick up only moderately as it remains constrained by the high interest rates needed to contain inflation, said Moody's, and added that without a stronger economic recovery, significant deleveraging of the corporate sector will not be easy.

The base-case forecast for India's GDP growth by the rating agency is 5.0% for the fiscal year ending March 2015 and 5.6% for the next fiscal year, compared with 4.7% in fiscal 2014.

"Although the new government of Prime Minister Narendra Modi may formulate some policies within the 12-18 month horizon of this outlook, it will take longer to see an impact on the real economy," Moody's said.

Profitability will also remain under pressure as banks continue to provide for problem loans, the agency continued. "This is particularly problematic for public-sector banks, which have lower pre-provision margins and greater asset quality problems."

State Support

At the same time, funding and liquidity will remain stable for Indian banks, given high domestic savings rates and a low reliance on market funding.

Moody's said it also expects a high degree of support from the Indian government for bank creditors to remain in place over the outlook horizon.

The Reserve Bank of India has sent recommendations aimed at compliance with the Financial Stability Board norms, but the government in practice will likely opt for other resolution mechanisms, such as assisted mergers, instead of "bail in", Moody's said.

"If senior creditors of an ailing public-sector bank were required to absorb losses, this could easily risk contagion of financial distress to other public-sector banks, given their similar business models and credit characteristics."

Moody's said it rates four private-sector and 11 public-sector banks in India that collectively account for 67% of system assets.