Moody's Investors Service has changed its outlook for India's banking system to negative from stable due to concerns that an increasingly challenging operating environment will adversely affect asset quality, capitalisation, and profitability.

"India's economic momentum is slowing because of high inflation, monetary tightening, and rapidly rising interest rates," says Vineet Gupta, a Moody's Vice President and Senior Analyst.

"At the same time, concerns have emerged over the sustainability of the recovery in the US and Europe, and the rise in the borrowing program of the Indian government, which could drain funds away from the private credit market."

Moody's rates 15 commercial banks in India, which together account for about 66% of the system's total assets as of March 2011. The system is dominated by public-sector banks, which account for around 75% of the market in asset terms. The weighted average stand-alone banking financial strength rating (BFSR) is D+, and mapping to a Baseline Credit Assessment of Baa3. The average long-term deposit rating is Baa2/Prime-2.

With asset quality, given the tightening environment, Moody's anticipates that it will deteriorate over the next 12-18 months, thereby causing an increase in provisioning needs for the banks in FY2012 and FY2013.

Meanwhile, with capitalization, Moody's expects loan growth to be a strain on the banks' capital over the horizon of this outlook. As monetary conditions tighten and economic activities slow, Moody's expects bank loan growth to fall to 16%-18% in FY2012 and FY2013, from 21% in FY2011.

"And with profitability, 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 liberalization on savings deposit rates," says Gupta.