Indian banks operate amid a challenging economic environment

There are uncertainties and risks regarding policies.

The Indian banking sector faces a challenging economic environment; although the new government's clear electoral mandate gives it the ability to pursue far-reaching economic reforms.

According to a release from Fitch Ratings, uncertainties and risks remain regarding implementation of key policies necessary to achieve the government's growth and fiscal deficit targets.

Fitch has increased its real GDP growth forecast for the financial year ending March 2016 (FY16) to 6.5% from 6.0% and projects real GDP growth to pick up to 5.5% in FY15 from 4.7% in FY14.

Asset quality at state-owned banks remains under pressure, while certain large banks' non-performing loans (NPLs) and restructured loans have grown at a slower pace in the recent two quarters.

Early signs of deleveraging in the corporate sector are encouraging. However, a recent court ruling that the government's allocations of coal assets in 1993-2009 were illegal has cast a shadow on asset quality.

However, the impact of the ruling may be less onerous than expected if productive assets are allowed to continue operating without disruption. Fitch expects the pressure on asset quality at the rated banks to persist for another couple of quarters.

The banks, particularly the state-owned ones, will increasingly focus on raising capital to meet more stringent capital requirements under the Basel III regulatory framework, which will be progressively implemented in India.

Here’s more from Fitch Ratings:

Fitch Ratings has affirmed the ratings on nine Indian banks. The Long-Term Issuer Default Ratings (IDR) on State Bank of India (SBI), Bank of Baroda, Bank of Baroda New Zealand (BOB NZ), Punjab National Bank, Canara Bank, IDBI Bank, ICICI Bank and Axis Bank have been affirmed at 'BBB-' while Indian Bank has been affirmed at 'BB+'. The Outlook on the IDRs is Stable.

The Long-Term IDRs of SBI, Bank of Baroda, Punjab National Bank, Canara Bank, IDBI Bank, and ICICI Bank are at their SRFs of 'BBB-'.

The ratings are driven by their SRs of '2', which reflects Fitch's expectation that they are highly likely to receive extraordinary support from the Indian government, if needed, due to their high systemic importance and the government's majority ownership in all except ICICI Bank.

Indian Bank - which is also state-owned - has an IDR and an SRF that are a notch lower than the large state-owned banks', driven by its lower SR.

Indian Bank's SR of '3' reflects the moderate probability that it would receive extraordinary support from the Indian government, if needed, because of its moderate systemic importance stemming from its smaller size and more regional character.

Axis Bank's IDR is driven by its VR at 'bbb-' while its SRF and SR are lower at 'BB+' and '3', respectively, mainly due to its private ownership.

The Viability Ratings (VRs) of SBI, ICICI Bank, Axis Bank and Indian Bank are at the same level as their IDRs and therefore, act as drivers for their long-term ratings.

BOB NZ is a fully owned subsidiary of Bank of Baroda and its IDR is driven by expectations of high support from its parent, Bank of Baroda, due to the various explicit and implicit linkages with the parent.

The VRs of certain banks will continue to be under pressure, but the affirmations on their VRs factor in efforts to raise capital and the expectation that asset quality would not deteriorate materially from current levels and reach their worst during the current financial year.

SBI, ICICI Bank and Axis Bank are the only ones among Fitch's rated Indian banks to have investment-grade VRs of 'bbb-', reflecting their superior stand-alone credit profiles.

The drivers for the private banks' (ICICI Bank and Axis Bank) VRs are their strong capital metrics, better-than-average asset quality, good profitability, robust funding profile and better management quality.

ICICI Bank has had a consistently strong capitalisation track record while Axis Bank has managed its asset quality better and made notable improvements to its capitalisation and retail funding.

SBI, whose financial metrics are not as strong as ICICI Bank's and Axis Bank's, benefits from its large scale and status as a quasi-sovereign entity, which results in a solid funding profile and strong access to capital markets.

A fresh equity injection of INR100bn (USD1.7bn) in FY14 in the bank has helped to replenish its capital buffers and raised its Fitch core capital (FCC) ratio to 10.5% in FY14 from 9.9% in FY13.

The bank plans to raise another INR200bn (17% of FY14 equity) over the next two years, which should hold capital buffers steady. The stressed assets ratio improved to 8.3% in 1QFY15 from 8.4% in FY14.

The VRs of Bank of Baroda, Canara Bank and Punjab National Bank are rated one notch lower at 'bb+', although Bank of Baroda's performance has been better than the other two in terms of capitalisation and exposure to stressed business sectors.

Capital buffers for all three banks remain stretched, particularly at Canara Bank and Punjab National Bank, which was a key factor in the VR downgrades for all three in 2013 and 2012.

Canara Bank's exposure to stressed sectors is among the highest in its peer group although its stressed asset ratio (9.5% in 1QFY15 up from 9.2% in FY14) is lower than state banks' average of 12% (FY14).

The ratio continued to rise even though total loans rose by 22% in FY14. The VR affirmation reflects expectations that Canara Bank will raise additional equity.

Although Punjab National Bank is more profitable than its peers, its capital buffers are thinner compared with its stressed assets stock of around 15% of total assets, the highest among the rated banks.

The bulk of the stressed assets are restructured loans. Although the growth in restructured loans has slowed recently, its NPL ratio rose to 5.5% in 1QFY15 from 5.3% in FY14.

Indian Bank's VR, which was also downgraded in 2013, reflects concerns about its rising stressed asset ratio (1QFY15: 11.9%), which are partly offset by its better capitalisation (FCC ratio of 12.6% in FY14) and slower loan growth.

IDBI Bank's VR is the lowest among the rated banks, and it is the most vulnerable to a downgrade given rapid deterioration in the stressed asset ratio to 14.5% in 1QFY15 from 9% in FY13 and 14.1% in FY14, and a very thin capital buffer (FCC ratio of 8% in FY14).

The bank has sharply slowed loan growth to focus on asset quality issues and is simultaneously seeking to raise capital.

Fitch will view efforts to strengthen its capital buffers positively because the agency expects asset quality pressures to persist into FY15.