OREANDA-NEWS. The standalone credit profiles of many Indian public sector banks should come under pressure unless there is meaningful action to restore capital adequacy, says Fitch Ratings. Significant quarterly losses reported at several large public banks last week, including Bank of Baroda and Bank of India, underscored long-standing balance-sheet and capital risks stemming from legacy issues pertaining to poor asset quality and weak provisioning.

Fitch's estimated capital need for the system of USD140bn may need to be reassessed, given some of the losses. But the revision should only be slight, considering that Fitch has long assessed India's banking system on a stressed-asset basis - rather than NPLs - and factored in under-provisioning in the ratings for public sector banks.

The sudden deterioration in profitability at many public banks in the third quarter (3QFY16) of the financial year ending March 2016 (FY16) was triggered mainly by higher provisioning resulting from the reclassification of certain loans. Pressure from the Reserve Bank of India (RBI) was a key factor driving the bulk of reclassification. The RBI had nudged banks (both public and private) to identify stressed accounts and significantly raise provisioning over two quarters through to FYE16.

It is unusual for the RBI to be driving state banks to raise provisioning so quickly, and indicates that earnings pressures will continue in 4QFY16 and possibly beyond. Fitch believes the RBI's intention to clean-up bank balance sheets by FY17 as a pre-requisite to kick-start credit growth could help to revive investor confidence in public-sector banks. But the suddenness and speed of the provisioning in 2HFY16 highlights how long it has taken to address poor balance sheets. It also raises questions over the pace and implementation of bank recapitalisation and reforms, especially when central bank intervention is required in identification of bad assets.

Fitch has long highlighted that provisioning at state banks is weak and that significant new capital was necessary to maintain credit profiles. However, the effect on earnings and credit profiles would have been less dramatic had the provisioning process been spread out over a longer period.

Notably, the impact on private-sector banks was relatively limited, with public-sector banks having to provide nearly 8x more for NPLs. This resulted in a cumulative loss of almost INR108bn (USD1.6bn) in 3QFY16; equating to nearly 43% of the INR250bn capital injection planned by government for FY16.

This indicates that there will be limited options for government but to provide more core capital than budgeted. Activity to raise additional Tier 1 capital has remained limited, while book valuations continue to trade at heavy discounts. Media reports have already been indicating that a package for additional capital for public banks is being prepared. Fitch expects government to remain generally supportive in providing capital; but the longer it takes to restore market confidence, the greater the likely cost. There has also been speculation that government may dilute its stake in the public banks in light of the enormous capital requirements. Fitch maintains that this is unlikely for now.

The small and mid-sized public banks appear to be most affected with severe losses. Smaller banks lack the funding flexibility, and also face higher asset concentration in particular sectors and regions. There is quite a high risk that some smaller banks' core capitalisation may fall below the regulatory minimum, with growth prospects likely to be weak - due to both poor capitalisation and asset-quality issues - and core capitalisation inching closer to the minimum Basel III requirements.