Growth in pre-provision earnings and decline in bad loans will improve profitability of banks in the current fiscal, a report said on Monday. Better profitability will offset increases in capital consumption due to an acceleration in loan growth, helping banks across the system maintain capital at current levels, Moody's Investors Service said in a report.

Capital ratios at Public Sector Banks (PSBs) have improved in the past year, helped by capital infusions from the government, it said. "Also, PSBs as well as their private sector peers have proactively sought to raise capital from the equity capital market, taking advantage of improvements in profitability to attract investor interest. Rated private sector banks had an asset-weighted average Common Equity Tier 1 (CET1) ratio of 15.8 percent at the end of 2021, which positions them well to capture opportunities to grow loans as economic conditions improve," it said.

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Further improvements in PSBs' financial health will continue to help them raise equity capital from the market, reducing their dependence on capital support from the government. The report further said, "gradual increases in domestic interest rates will boost net interest margins because banks will be able to pass on higher rates to borrowers, while their funding costs will increase marginally because banks have reduced the share of high-cost corporate term deposits in total deposits."

Stable asset quality and existing provisions against legacy stressed assets will allow banks to reduce loan-loss provisions, it said, adding, the return on assets of rated PSBs and private sector banks rose materially to 0.6 percent and 1.5 percent, respectively, in the nine months ended December 2021 from -0.4 percent and 0.7 percent in the fiscal year ended March 2018. Non-Performing Loan (NPL) ratios will decline because of recoveries or write-offs of legacy problem loans while formation of new NPLs will be stable as the economy recovers, it said.

Loan growth will help push NPL ratios down by expanding the overall pool of loans even though new defaults may arise from loans that have been restructured because of economic disruptions from the pandemic, it said. On the economic outlook, it said, India's economy is expected to recover in the next 12-18 months with GDP growing 9.3 percent in the year ending March 2022 and 8.4 percent in the following year.

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Improving consumer and business confidence as well as improving domestic demand will support economic growth and credit demand, it said. However, it said, the global economic fallout from the Russia-Ukraine military conflict will create some risks, as it fuels inflation because of rising oil prices and driving down the value of the local currency, which will increase pressure on India's central bank to raise interest rates.

Increasing corporate earnings and easing funding constraints for non-bank finance companies, which are significant borrowers from banks, will support loan growth, it said, adding that the loan growth is expected to accelerate to 12-13 percent in FY23 from 5 percent in FY21.