Capital from the Government will be crucial to support weak capitalisation and challenges of poor asset quality of India's state banks through the medium term, said Fitch Ratings in a report.

"State support will remain crucial for public banks - considering the shallow domestic AT1 (additional tier 1) market and weak internal capital generation capabilities - as the sector as a whole seeks to raise an estimated $140 billion in new capital required by FY19," a Fitch statement said.

This will especially be the case over the next one to two years as state banks work though the pressures of their stressed assets, and repair their balance sheets, it added.

Considering this, the government's capital plan calls for public banks to raise 60% of their required capital in the market, and this may be overly ambitious.

Constraints of PSBs

So far, public sector banks have barely managed to raise the required capital to meet Basel III norms.

The weak state of the public banks weighs on India's banking sector as a whole, with core capitalisation generally weaker than regional peers as a result.

"Average capitalisation at state banks is even worse when adjusted against a significant stressed asset stock and low-to-moderate provision cover," Fitch said.

The Government's July announcement to inject Rs 70,000 crore ($11 billion) in core equity through to FY19 - Rs 25,000 crore in FY16 - will provide state banks with a much-needed immediate capital buffer, but may not provide sufficient support over the long term.

Capital raising from market

The domestic AT1 market lacks depth and liquidity, which has been a constraining factor for public banks to raise substantial amounts of new capital.

Further, it said that domestic investor interest has been limited, with state banks not issuing any AT1 instruments in the market since March 2015.

According to Fitch, there is a growing mismatch between investor expectations and the level that banks are willing to pay for loss-absorbing instruments. The ability of the domestic market to meet the capital needs of the public banks remains uncertain, and it is only a matter of time before public banks seek AT1 funds internationally.

On the other hand, private banks are in a much stronger capital position, and do not face the enormous challenges of their public counterparts. The private-sector banks already benefit from stronger capitalisation, high internal accruals, higher equity valuations and much lower asset-quality issues. They have also been proactive in raising core equity at regular intervals.

The August 31 decision by the RBI to designate State Bank of India and ICICI Bank as Domestic Systemically Important Banks (DSIBs) reflects in part some of the broader capital challenges in India.

The fact that the RBI designated only two banks as DSIBs reflects the already large capital requirement and the broader challenges financial institutions will face in meeting it.

Fitch expects more banks to be designated DSIBs in future.

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