New Delhi: Moody's Investors Service today upgraded its outlook for India's banking system to 'stable' from 'negative' on expectation that a gradual improvement in the operating environment for lenders will lead to lesser growth in bad loans in future.


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Moody's had assigned a negative outlook to the Indian banking system in November 2011 as it was of the view that the asset quality of the lenders was deteriorating.


"The stable outlook on India's banking system over the next 12-18 months reflects our expectation that the banks' gradually improving operating environment will result in a slower pace of additions to loans problem, leading to more stable impaired loan ratios," Moody's VP & Senior Credit Officer Srikanth Vadlamani said.


In the report titled 'Banking System Outlook of India: Gradual Improvement in Operating Environment Drives Stable Outlook', Moody's said the stable outlook is based on Moody's assessment of five drivers -- improving operating environment, stable asset risk and capital, stable funding and liquidity.


Also stable profitability and efficiency and the government support has supported a stable outlook for the sector, it said adding the recovery in the asset quality would be U-shaped rather than V-shaped, because corporate balance sheets remain highly leveraged.


On the operating environment, Moody's expects that India will record the GDP growth of around 7.5 per cent in 2015 and 2016.


"Growth has been supported by low inflation and the gradual implementation of structural reforms. An accommodative monetary policy should support the growth environment," the report said.


As for asset risk and capital, Moody's said that asset quality will stabilise. In particular, while the banks' stock of non-performing loans may continue to rise, the pace of new impaired loan formation in the current financial year ending March 2016 will be lower than the levels seen in the past four years. 


Moody's, however, said the capital levels of public sector (PSU) banks are low and the government's announcement of injecting Rs 70,000 crore into PSU banks over the next four years is "clear positive".


"But this amount is still short of the banks' overall capital requirements. Ability to access equity capital markets remains key if the PSU banks have to address their capital shortfall," it said, adding high capital levels are a credit strength of the private-sector banks.


As for funding and liquidity, these factors are credit strengths for Indian banks because retail deposits are their primary source of funding.


"Most banks comply comfortably with required liquidity coverage ratios, even though only part of their holdings of government securities is categorised as high-quality liquid assets," it added.


Moody's said for the PSU banks in particular it expects that the government will not make any changes that could suggest the possibility of reduced support to or differentiation among the banks, because doing so could entail significant systemic risks.


Moody's rates 15 banks in India that together account for around 70 per cent of system assets. Four are private-sector banks and the remaining 11 are PSU banks.