Indian banks would face a capital shortfall of about $58 billion (about Rs 4.38 lakh crore) in the event of a high-stress situation where the domestic economy fails to recover from the coronavirus pandemic-related disruption, says Fitch Ratings. Under a moderate stress scenario, the banks are likely to require at least $15 billion (around Rs 1.13 lakh crore) in fresh capital to meet a 10 per cent weighted-average common equity Tier 1 ratio, it said.

"State banks will require the bulk of the recapitalisation, as the risk of capital erosion at state banks is significantly higher than for their privately owned peers," Fitch said in its latest report 'Indian Banks Vulnerable to Pandemic-Related Stress'.

Fitch warned that banks may continue to face heightened asset quality and earning pressure for at least next two years, as disruption to business activity and supply chains and shrinking personal incomes damage banks' balance sheets. As per the report, public sector banks were more vulnerable than private banks coming into the crisis, with weaker loss-absorption buffers, and appear to be shouldering a disproportionate share of the burden in bailing out affected sectors.

The American credit rating agency expects the majority of the injection to come through in FY22, as bad loan recognition has been pushed back by a 180-day regulatory moratorium. According to the agency, a clearer picture would start to emerge from December 2020, unless the Reserve Bank of India (RBI) agrees to a one-time loan restructuring, which would affect the timely recognition and resolution of bad loans.

The financial reports of Indian banks for the financial year ending March 2020 (FY20) do not adequately reflect the incipient stress caused by the COVID-19 pandemic, Fitch said. "The results are broadly in line with Fitch's expectations, but bank balance sheets are yet to feel the impact of India's strict lockdown measures that were implemented by the government from 25 March 2020," it added.

The agency warned that a short-term recovery looks unlikely, as the acceleration of new COVID-19 cases threatens the gradual reopening of the economy. Fitch expects the economy to contract by 5 per cent in FY21, followed by a recovery in FY22, but with considerable downside risk.

"The impaired loan ratios of Indian banks trended down in FY20, in line with our expectations (FY20e: 8.5 per cent; FY19: 9.3 per cent), driven by fewer fresh impaired loans and continued write-offs (FY20: 2 per cent of loans). Several state banks also returned to profitability due to easing credit costs, but the banking sector's return on assets was low (FY20e: 0.22 per cent)," Fitch said.

Bank's core capitalisation improved by about 90 basis points (bps) to 11.3 per cent in FY20, mainly due to a $9 billion government equity injection into state banks coupled with lower growth, which implies high risk aversion among banks, particularly those that are state owned. State banks' core capitalisation was about 350 bps weaker than that of private banks, despite the fresh equity, leaving their limited capital buffers susceptible to stress.

Fitch sees a well-functioning banking sector as supportive of achieving sustained economic growth of 6-7 per cent, but without timely and adequate recapitalisation, banks will continue to display heightened risk aversion, adding to India's economic uncertainty.