further deteriorate, leading to decline in profitability due to slow economic growth and high interest rates.
Moody's Investors Service in a statement said, "its outlook on the Indian banking system for the next 12-18 months remains negative - as it has been since November 2011 - reflecting the continued challenging nature of its domestic operating environment".
Moody's rates a total of 15 public sector and private sector banks, which together accounted for about 66 per cent of the banking system's estimated total assets on March 2012.
The gross gross NPAs or bad loans of all public sector banks taken together has increased to 4.01 per cent in the second quarter of the fiscal from 3.06 per cent in the year ago period.
As per the agency, banks' average standalone credit strength is D+, or ba1 on the long-term rating scale, whereas their average foreign currency long-term deposit rating is Baa3, which is investment grade.
Moody's said India's environment is characterised by slow economic growth, high inflation, high interest rates, and a weak local currency.
"...we expect these factors to lead to a further deterioration in asset quality, an increase in provisioning costs, and a fall in profitability," said Vineet Gupta,
Moody's Vice President and Senior Analyst.
Moody's also expects the high level of loan growth, at about 15 per cent annually, to outstrip internal capital generation.
"...then most of the Moody's- rated Indian banks will bechallenged to maintain capitalisation levels at current levels, and some will even need to raise new capital
externally," Gupta added.
However, on the positive side, one anchor of stability for Indian banks is their strong business franchises. he said.
The agency also "continues to assume" a relatively high probability of systemic support, as the government already provides annual equity infusions for public sector banks.
"This implies a high degree of involvement by the government in the banking sector and related public accountability," it said.
Moody's believes that the government would provide extraordinary support in the form of unsecured loans and capital injections to both the public and rated private banks.
The government will decide on Rs 15,000 crore capital infusion in public sector banks to shore up their capital base this week.
India's economic growth slipped to a near decade low level during the second quarter of this fiscal amid high interest rates and inflation.