"This environment is characterized by slow economic growth, high inflation, high interest rates, and a weak local currency, and we expect these factors to lead to a further deterioration in asset quality, an increase in provisioning costs, and a fall in profitability," Vineet Gupta, a Moody's Vice President and Senior Analyst said.

"And when we also consider the high level of loan growth which, at about 15% annually, is expected to continue outstripping internal capital generation, then most of the Moody's-rated Indian banks will be challenged to maintain capitalization levels at current levels, and some will even need to raise new capital externally," adds Gupta.

Furthermore, Moody's views the loan classification - more particularly with regards to restructured loans - and provisioning practices in India as weak. "Loan classification and provisioning requirements mask the extent of the banks' asset quality and capital challenges," says Gupta.

"On the positive side, one anchor of stability for Indian banks is their strong business franchises, which support their low-cost funding profiles, helping them maintain sizable lending margins to sustain pre-provision earnings," says Gupta.

Moody's also continues to assume a relatively high probability of systemic support, observing that the Indian government already provides strong ongoing support in the form of annual equity infusions for the public sector banks, and all banks are mandated to meet loan quotas for certain sectors of the economy. This implies a high degree of involvement by the government in the banking sector and related public accountability.

If needed, Moody's believes that the government would provide extraordinary support in the form of unsecured loans and/or capital injections to both the public and the rated private banks.

Moody's rates a total of 15 public sector and private sector commercial banks, which together accounted for about 66% of the system's estimated total assets as of March 2012. Their average (asset-weighted) standalone credit strength is D+, or ba1 on the long-term rating scale, whereas their average foreign currency long-term deposit rating is Baa3, which is investment grade.

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