The outlook for most of India's state lenders remains "quite weak" despite extensive reforms in the banking sector, according to a senior asset manager.
While it is predicted that corporate asset quality for India's public sector banks will improve from here on, the sheer volume of bad assets that they own puts a bit of a dampener on their future, said Rana Gupta, managing director for Indian equities at Manulife Asset Management.
"They still need to run out their coverage, so credit cost will still be high," Gupta told CNBC's "Street Signs" on Tuesday. Additionally, high managerial costs and low profitability would mean most of those banks are not generating capital, he said.
"Therefore, barring the top one or two state-owned banks, (for) the balance — the outlook still remains quite weak," Gupta said. "In fact, we would expect, whenever the election is over and the new government comes in, if it's a stable government, we'd expect more consolidation to follow."
Banks are a key source of funding for Indian companies. Public sector financial institutions control about 70 percent of all banking assets in India and they have had the highest exposure to bad loans. To tackle the problem, the government and the country's central bank — the Reserve Bank of India — introduced a series of measures to clean up the struggling lenders. That includes the merger of three public sector banks.
The bad debt situation has shown signs of improvements through recent bank earnings reports as well as resolutions happening under India's insolvency and bankruptcy act. The central bank previously predicted that the ratio of gross non-performing assets may decline further.
That said, the recovery in the banking sector may potentially stall after last week's Supreme Court ruling that voided the central bank's guidelines on how lenders should resolve their bad debts. Ratings agency Moody's had already signaled the decision was bad news for banks.
The RBI guidelines, issued in a circular released in February last year, said lenders could no longer use loan restructuring schemes to delay recognizing bad debt. Banks were given 180 days to put resolution plans in place for defaulting assets worth over 20 billion rupees (about $291 million). If companies missed repayment even for a day, lenders were required to identify them as defaulters, therefore file for a resolution plan.
If a resolution did not happen by the 180-day period, banks were required to file insolvency proceedings against those borrowers within 15 days.
"These are very stringent guidelines," Gupta said. "The upside of the (Supreme Court) ruling is that banks and the corporates, they get some flexibility to restructure their debt. But, the downside is if the banks take this opportunity and they kick the can down the road."
He added that it is likely the RBI, under its new governor, will further consult with the government and industry stakeholders before coming up with newer guidelines that will leave breathing room for lenders, while also preventing them from prolonging the issue of bad debts.
Starting this week, India heads to the polls to elect members for the lower house of its Parliament. The outcome, to be announced in May, will determine if Narendra Modi can secure a second term as prime minister.