The decision of Moody’s Investor Service last Wednesday to change its outlook on India’s banking system to ‘negative’ from ‘stable’ need not have come as a surprise. A month ago, Moody’s cut the standalone rating of State Bank of India, the country’s largest bank, citing concerns over capital and weakening loan quality. Some of these concerns have again been cited to justify the downgrade of the entire banking sector. There is no doubt that a slowing economy will witness a rise in loan defaults and they will have to be provided for. An increased recourse to provisioning will naturally impinge on the bank’s profitability. Besides, in a scenario of rising interest rates, banks will have to offer a higher interest on their deposits and this will naturally shrink their interest rate margins. It is also true that raising fresh capital will be more difficult and expensive in times of slowdown. Moreover, the global economic environment is chaotic and not conducive to the stability of the financial sector. These as well as the more specific factors responsible for slowing down the Indian economy — high inflation, rising interest rates, and monetary tightening — are easily understood. Moody’s decision has inevitably drawn strong criticism from the banks, the government, and many independent analysts, who are convinced that the Indian banking system is healthy and that banks are adequately capitalised. Problems in specific sectors such as power are no doubt a cause for concern, but they are not sufficient reasons for a general downgrade of the banking system.
The Reserve Bank of India’s Financial Stability Report (June 2011) indicated that the domestic financial system remained stable “in the face of some fragilities being observed in the global macro financial environment.” Compared to their peers in developed countries, Indian banks are surely better regulated and do not deal in exotic products. The downgrade will raise the cost of borrowing by Indian banks in overseas markets. It is small consolation that Moody’s has assigned a ‘stable’ outlook to 14 of the 15 banks rated by it in India, even while downgrading the entire sector. It, however, helps that Standard & Poor’s, another large rating agency, has chosen to upgrade India’s banking sector, the very next day. The rating process does not quite capture the strengths and weaknesses arising from government ownership of a majority of banks. One important source of strength is that the government remains committed to providing capital to the banks. On the other hand, the downgrade of SBI was primarily caused by the government’s procrastination about subscribing to a rights issue of shares that the bank has been planning for quite some time.
