The government risks creating "moral hazard" by injecting funds into state-run lenders such as IDBI Bank Ltd which are at risk of missing coupon payments on their additional tier 1 bonds, Fitch Ratings said on Wednesday.
Fitch said India's injection of 19 billion rupees ($295.81 million) into IDBI on Aug. 9 - at a time when the lender was believed to be at risk of missing a coupon payment on an additional tier 1 (AT1) bond - clearly showed the government's unwilligness to allow defaults in the market.
The credit agency said the government was seeking to avoid a default that would disrupt markets and prevent other Indian lenders from raising capital from debt investors, but warned that was raising expectations the state would continue to bail out lenders in similar situations.
Such bailouts also create "moral hazard" by weakening incentives for state-run lenders which are struggling to meet bond payments "to recapitalise by raising equity on a more timely and pro-active basis," Fitch said.
"Market pricing appears to assume that the government is likely to continue to ensure state banks do not miss coupon payments," Fitch said.
AT1 bonds have been a popular fundraising option for Indian lenders, but they are riskier than regular debt since owners would typically first absorb the losses over senior creditors.
India's state-run lenders are struggling to clean up bad debt in their portfolios at a time when they face hefty capital requirements to meet upcoming Basel III rules.