Moody's Investors Service has downgraded Central Bank of India (CBI) and Indian Overseas Bank's (IOB) local and foreign currency deposit ratings to Ba1 from Baa3. At the same time, IOB's senior unsecured debt, issued from its Hong Kong branch was also downgraded to Ba1 from Baa3.

The rating action reflects Moody's assumption of a lower level of support from the Government of India (Baa3, Stable) following the government's recent announcements that indicate that it wishes to differentiate between state-owned banks (SOE banks) when distributing capital.

Moody's continues to assume a very high probability that the government would support these two SOE banks. However, the change of government policy means that the standalone credit quality of public sector banks has become a more important consideration for the senior unsecured and deposit ratings of the banks compared to previously when Moody's rated all SOE banks at the same level as the Government of India.

At the same time, Moody's has maintained its negative outlook on CBI's local and foreign currency deposit ratings.

Moody's has also maintained its stable outlook for IOB's senior unsecured debt and local and foreign currency deposit ratings.

The government's recently announced criteria for allocating new capital to SOE banks represents a marked departure in its approach to allocating capital until now. Under the new criteria, the government will give preference in allocating capital to banks whose average return on assets over the past three years and whose return on equity over the past one year surpass the corresponding weighted average ratios of SOE banks overall. In contrast, over the last four years, banks with weaker capital levels received higher capital allocations, regardless of their size or profitability.

Moody's notes that this new approach has been reflected in the capital allocations earmarked for the fiscal years ending March 2015 and March 2016.

For FYE3/2015, the government only allocated Rs 69.9 billion from its initial budget projection of Rs 112.0 billion, and only 9 banks-which had satisfied the profitability criteria -- actually received capital. For FYE3/2016, the government has only allocated Rs 79.4 billion for capital infusions even though the capital requirements of the SOE banks remain at high levels.

CBI and IOB have the weakest standalone credit profiles among Moody's rated Indian banks, as indicated by their baseline credit assessments (BCA) of b3 and b2 respectively. As a result, their previous supported senior ratings of Baa3 relied on more notches of government support relative to other rated SOE banks. Consequently,to reflect the impact of the government's establishment of more selective criteria, Moody's has lowered the notches of support provided to these two banks

At the same time, the revised ratings of Ba1 for CBI and IOB continue to incorporate a high level of government support, reflecting the government's goal of preserving systemic stability and enabling credit growth.

The government is likely to provide enough support to ensure the continued viability of these banks, particularly at a time when many SOE banks have low capital levels and elevated non-performing loans, as SOE banks which do not satisfy the profitability criteria constitute a material part of the Indian banking system.