Chennai: Global credit agency Moody’s Investors Service on Monday cautioned the Indian government of significant systemic risks to the banking system if it reduces support to banks or differentiate among them.

The rating agency also said the Rs.700 billion capital planned to be injected into government banks over the next four years is insufficient.

The credit rating agency seeing gradual improvement in the operating environment for Indian banking system changed its outlook on Indian banking system from negative to stable.

The stable outlook is based on Moody’s assessment of five drivers: Operating Environment (improving); Asset Risk and Capital (stable); Funding and Liquidity (stable); Profitability and Efficiency (stable); and Government Support (stable).

In relation to government support, Moody’s says the Indian government will continue to provide a high level of support to the banks.

For the public sector banks in particular, Moody’s 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.

“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 problem loans, leading to more stable impaired loan ratios,” Srikanth Vadlamani, Moody’s vice president and senior credit officer, was quoted in a statement issued by the firm.

Moody’s said deteriorating asset quality was the key driver of Moody’s negative outlook on India’s banking system since November 2011.

“However, the recovery in asset quality will be U-shaped rather than V-shaped, because corporate balance sheets remain highly leveraged,” adds Vadlamani who authored the report titled Banking System Outlook — India: Gradual Improvement in Operating Environment Drives Stable Outlook.’

The credit rating agency expects India to record a gross domestic product (GDP) growth of around 7.5 percent in 2015 and 2016.

Growth has been supported by low inflation and the gradual implementation of structural reforms.

According to Moody’s, an accommodative monetary policy should support the growth environment.

As for asset risk and capital, Moody’s says 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 31 March 2016 will be lower than the levels seen in the past four years.

Capital levels, however, are low for public sector (PSU) banks.

Such banks exhibit common equity Tier I ratios of only six-ten percent and their coverage of non-performing loans with loan-loss reserves averages 55 percent.

Terming the Indian government’s decision to inject Rs.700 billion into public sector banks over the next four years as a credit positive, Moody’s said the amount is short of overall capital needs of the banks.

“Ability to access equity capital markets remains key if the public sector banks have to address their capital shortfall,” Moody’s said.

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, the rating agency said.

Moody’s rates 15 banks in India that together account for around 70 percent of system assets. Four are private-sector banks and the remaining 11 are public sector banks.