Earlier this week, the government had announced its plans to bring down its stakes in 27 public sector banks (PSBs) to 52 per cent by 2019 to enable them to raise capital from the markets.
The government said PSBs are permitted to bring down government holding to 52 per cent in a phased manner, they can raise up to Rs 1,60,825 crore from the market.
"We expect access to core equity to remain challenging with state banks largely trading below book value," global rating agency Fitch said in a report.
"As such, state-owned banks will likely have to continue relying on additional tier 1 (AT1) hybrid instruments to strengthen capitalisation in the short term, despite the government's planned sell-downs," the report said.
According to Fitch, the banks will have large Basel-III capital needs totalling USD 200 billion by 2019, of which state-owned banks will account for around 85 per cent.
State-run banks have been slow in issuing AT1 capital, with only two issues of Rs 2,500 crore each - Bank of India in August 2014 and IDBI bank in October 2014. Combined, these two issues constitute roughly 5 per cent of the Fitch estimated total AT1 requirement through to 2016.
"This affirms our view about the uncertainty regarding the ability of the domestic market on its own to fulfil the AT1 requirement of banks," the report said.
It said the progress to strengthen capital has been slow due to a low internal rate of capital accretion and limited access to core equity - owing to below-book valuations for many banks.
Fitch said for most of the state-run banks, asset quality and earnings continue to remain stressed despite signs of economic revival.
Expectations of higher restructuring in H2 of FY15 and muted credit growth could further mean that earnings recovery will be slow and protracted, the report said.
"As such, the plan to reduce government stakes may have to wait until there is a meaningful recovery in earnings and, therefore, equity valuations," Fitch said.
State banks account for nearly 75 per cent of total banking system assets, but hold 90 per cent of the system's stressed loans, with the stress on mid-sized state banks being particularly acute.
Fitch said a cyclical recovery in FY16 should help ease the level of stressed assets, which it expects to peak by March 2015.