Moody’s Investors Service on Friday said that India’s plunging economic growth induced by the pandemic will damage country’s public sector banks’ (PSBs) asset quality and profitability. Consequently, the struggling PSBs will need external capital of up to Rs 2.1 trillion over the next two years.

“We expect to see PSBs’ already weak capital buffers to be depleted, with Rs 1.9 trillion – Rs 2.1 trillion (USD 25 billion – USD 28 billion) in external capital needed over the next two years to restore loss-absorbing buffers,” Moody’s Vice President and Senior Credit Officer Alka Anbarasu said.

PSBs dominate India’s banking system, meaning any failure could jeopardize financial stability, Anbarasu added.

“The most likely source of capital to plug the capital shortfalls will be government support, despite the completion of a large recapitalisation by the government several months ago,” she said.

The report, titled ‘Coronavirus fallout will leave banks with capital shortages again’ predicted that asset quality will deteriorate, led by retail and small business loans.

As per Moody’s, Indian economy will contract sharply in fiscal year ending March 2021 (fiscal 2020) before returning to growth, though modestly, in fiscal 2021.

“As a result, formation of new non-performing loans (NPLs) will accelerate substantially, driven by the retail and micro, small and medium enterprises (MSME) segments. Although one-time loan restructuring allowed by the Reserve Bank of India (RBI) will prevent a sudden increase in NPLs. NPLs and credit costs will increase in the next two years, hurting PSBs’ already weak profitability and depleting their capitalization,” it said.

According to the report, the PSBs will face large capital shortfalls again as credit costs rise. “Under our base scenario, we estimate PSBs in the aggregate will need external capital of about INR 1.9 trillion-2 trillion in the next two years. Of the total amount, PSBs will need about INR 1 trillion to build loan-loss provisions to about 70 per cent of NPLs, which will leave them with enough capacity to grow loans 8-10 per cent annually, faster than the 4 per cent in fiscal 2020,” it said.

“With a capital infusion of this magnitude, banks would also be able to maintain capitalisation at levels comparable to those of similarly rated peers globally, with Common Equity Tier 1 (CET1) ratios of at least 10 per cent, “ it added.

Moody’s said to maintain financial stability, government will continue to provide capital support for PSBs.

“Uncertainty surrounding India’s economic recovery as well as the ongoing clean-up of balance sheets are making it difficult for most PSBs to raise equity capital from markets. This means PSBs will continue to need support from the government to plug their capital shortfalls, and we expect the government to infuse fresh funds into them as it has done in the past,” the investors service said.

“If PSBs, which dominate the banking system in India, fail to function properly in the absence of state capital support, the country will face a deepening credit crunch, hampering its economic recovery,” Moody’s added.