State-owned banks account for more than two-thirds of the sector's assets and about 85 percent of bad debts - a major headache for policymakers keen to support a slowing economy.
The magnitude of the debt-mess was laid bare late last month when two of India's largest private sector lenders provided unprecedented guidance on non-performing loans, underscoring repeated warnings by Reserve Bank of India's governor Raghuram Rajan on the need to clean up banks' balance sheets.
The dangers are clear cut. Increasing provisions to cover rising bad loans are likely to hurt banks' profits and curb credit growth, stoking a vicious circle of lower economic growth triggering more defaults and choking off business investment and production.
Indeed, banks' loan growth at 10.7 percent in the last fiscal year ended March 31, was the slowest in nearly two decades, partly on lower lending to debt-heavy sectors such as iron and steel that account for the lion's share of bad debt.
Profits at most lenders have also taken a hit in the past six months as they set aside a higher sum to cover for defaults after a clean-up exercise ordered by the RBI.
"The banks need to keep provision covers high," said Abhishek Bhattacharya, a director at Fitch's Indian affiliate, India Ratings and Research. "That all points to the fact that the earnings should continue to be under pressure."
Bhattacharya estimates about Rs 13 trillion ($195 billion), or a fifth, of bank loans are already stressed - bigger than the size of New Zealand's economy.
That compares with Rs 8.06 trillion of distressed loans reported as of December or 11.5 percent of India's entire bank debt, meaning more pressure on profits.
DEEP SURGERY
RBI's Rajan, who wants banks to fully disclose and provide for bad debt by March 2017, is calling for "deep surgery" to clean up the balance sheets.
Investors and analysts have long suspected that Indian lenders, especially the dominant state-run banks, are not disclosing the true extent of their troubled loans to avoid having to raise provisions.
But granular details released for the first time last month by ICICI Bank and Axis Bank - India's no. 1 and no. 3 private sector lenders respectively - highlighted the depth of the problem.
Axis Bank disclosed it had put Rs 22,600 crore billion (Rs 226 billion) of its loans on a 'watch list', and was expecting 60 percent of those to default within two years. That would mean its bad debt could triple from the Rs 6,088 crore (Rs 60.88 billion) reported at end-March.
ICICI said some Rs 52,500 crore (Rs 525 billion) of loans to struggling sectors including steel and power had been put on watch.
Moody's estimates bad loans at the 11 state-run banks it rates to be between 10.5 and 12 percent, compared with the 7.2 percent reported as of end-December.
"The ability of (state) banks to support economic growth or to provide loans will ultimately depend on how the government will support them in terms of capital," said Alka Anbarasu, a Singapore-based vice president at Moody's.
These state-owned banks account for more than two-thirds of the sector's assets and about 85 percent of bad debts - a major headache for policymakers keen to support a slowing economy.
"It could get worse before it gets better is the sense we have," India Ratings' Bhattacharya said.
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