"With asset quality, given the tightening environment, we anticipate that it will deteriorate over the next 12-18 months, thereby causing an increase in provisioning needs for the banks in FY2012 and FY2013," Moody's Vice-President and Senior Analyst Vineet Gupta said.
A "negative" outlook is one that is characterised by volatility and uncertain conditions, according to Moody's. On the positive side, however, the rating firm has recognised that India banks' stable customer deposit base and their high level of government securities holdings provides them with a "resilient funding and liquidity profile" that buffers them against destabilising shocks.
India's economic growth has averaged 8.4 per cent over the past five years. But amid high inflation, monetary tightening and rapidly rising interest rates, the sustenance of the growth momentum is under pressure.
Stating that India's economic momentum is slowing, Gupta said, "At the same time, concerns have emerged over the sustainability of the recovery in the US and Europe and the rise in the borrowing programme of the Indian government, which could drain funds away from the private credit market."
Loan growth would be a "strain" on the Indian banking system in the next 12-18 months, while profitability will come under pressure due to lower interest margins and an increase in saving deposit rates, the report said.
"As monetary conditions tighten and economic activities slow, we expect bank loan growth to fall to 16-18 per cent in FY2012 and FY2013 from 21 per cent in FY2011," Gupta said.
On profitability, Moody's said, "We expect it to come under pressure due to lower interest margins as deposit rates re-price and get a further push from the latest liberalisation on savings deposit rates."
Moody's rates 15 commercial banks in India, which together accounted for about 66 per cent of the system's total assets as of March, 2011. The system is dominated by public sector banks, which account for around 75 per cent of the market in asset terms.
Moody's further said that individual bank ratings may come under downward pressure. "For those banks with weaker capital ratios on average and higher asset quality pressures relative to their individual rating levels, their standalone ratings are likely to come under pressure," Moody's said.
Last month, Moody's had downgraded its rating of State Bank of India's (SBI) financial strength on account of the lender's low Tier-I capital ratio and deteriorating asset quality. The negative outlook on the banking system, however, contrasts with the stable outlook assigned to the financial strength ratings of 14 of the 15 rated banks.
Moody's also expects the government to remain committed to providing support to both public and private banks.