The report, however, said that external capital will help banks maintain capital ratios.

The operating environment for Indian banks will be stable but economic slowdown poses challenges to the sector, a Moody's Investors Service report said on Monday.

According to the report - the India banking system outlook - the country's economic growth will remain weaker than in prior years at a time when lenders are recovering from legacy non-performing loans (NPLs).

"Despite stability in the country's macro fundamentals, stress among NBFIs (non-banking financial institutions) will continue to constrain economic growth," the report said.

The stress faced by NBFI sector and economic slowdown can also hamper asset quality improvements, the report said.

"The formation of new NPLs in the non-financial corporate segment will further slow, helped by improved financial health of corporates and recoveries from legacy problem loans.

"However, stress at NBFIs is a risk to banks' asset quality because banks have large exposures to the sector. In addition, the moderation of economic growth could lead to the creation of new NPLs in the retail and small and medium enterprise (SME) segment," it said.

The report, however, said that external capital will help banks maintain capital ratios.

"Capital infusions from the government will help public sector banks maintain their capital ratios at current levels," the report said.

"Furthermore, as their credit profiles improve, some will be able to raise capital from the equity market. Some rated private sector banks are in the process of raising new capital from the equity capital market as their asset growth outstrips internal capital generation."

Profitability will improve marginally as credit costs decline, the report said.

"System wide profitability will improve but stay weak, with net interest margin (NIM) to widen modestly and credit costs to decline but remain high," it added.

