Mumbai (Maharashtra) [India], Sept 11 (ANI): The proposed further consolidation of Indian state-owned banks should be a long-term positive for the industry but not necessarily a remedy for its near-term challenges, Fitch Ratings said on Wednesday.

A less fragmented banking system with larger, more diversified stable players that benefit from stronger profitability through economies of scale will be viewed positively from a credit perspective. However, this change must be accompanied by adequate capitalisation and meaningful governance reforms, it said.

Under the merger plan announced on August 30, Punjab National Bank, Canara Bank, Union Bank of India and Indian Bank are likely to be the four surviving entities merged down from 10, with state-owned banks consolidating from 27 in 2017 to 12 in this third instalment of the government's consolidation agenda.

The plan comes on the heels of Bank of Baroda's merger with two smaller banks (Vijaya Bank and Dena Bank) in April and State Bank of India's merger with its five associate banks in 2017. The consolidated banks will see a 42 per cent increase in assets, with 56 per cent of the system's commercial bank business, and expand their geographic footprint with an additional 4,000 branches.

"The consolidation and implementation risks of building a well-capitalised, competitive and profitable banking system are considerable. However, the long-term benefits far outweigh short-term challenges that tend to be associated with a sector consolidation process," said Fitch.

A well-structured banking system with sufficient lending capacity to fund corporate growth is necessary for economic expansion as India expands its global reach. A more effective resolution of stressed assets under a less fragmented banking system is also expected to benefit the sector.

"Confrontational trade unions pose the most immediate challenge for the proposed mergers while integrating cultures will be significantly important over the long term. Bank performance is likely to remain below average for the next two years with the country's slowing economic growth challenging the sector's weakened intrinsic creditworthiness, particularly at state banks," said Fitch.

Once capitalised, large state banks will be expected to lend more and take additional risk which could affect their intrinsic risk profiles without proper governance. However, governance reforms have fallen short of expectations with bank executive and managerial positions often left vacant for months due to lack of advisory oversight and lower relative compensation.

A recent proposal to appoint a professional chief risk officer with market-rate compensation may be difficult to implement as pay levels for state banks are well below those of private banks.

Governance reforms are further challenged when the state holds a majority stake and has direct or controlling influence through leadership appointments and board representation. Majority state ownership is the main link between the three banks, which have existed independently for decades with their own regional franchises and differences in culture.

The Rs 36,700 crore infusion of fresh equity likely to be front-ended by the state to the four anchor banks for the merger should help offset the near-term capital shortfall and merger-related impacts that may weigh on their financials. However, it will not be enough to pursue meaningful credit growth.

Fitch estimates that the Indian banking sector will require an additional 13 billion to 15 billion dollars until financial year 2020-21 to satisfactorily achieve the above objectives.

Near-term downside risks include deteriorating credit quality and potential capital shortfalls which are reflected in Fitch Rating's negative outlook on the Indian banking sector. While authorities have not set a deadline for effective implementation, it is unlikely before April 2020, given the recent integration of the Bank of Baroda merger.

Bank of India is the only large non-consolidated bank which makes it a likely anchor bank for future consolidation for the remaining small banks currently under the central bank's prompt corrective framework.