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In a marked rejoinder to the regular calls at home for more expansionary lending, Moody’s Investors Service said on Tuesday that the outlook for the domestic banking sector over the next 12 to 18 months was negative due to worsening loan quality and declining profits.

In its outlook, written by Beatrice Woo, Moody’s vice president and senior credit officer, the ratings agency highlighted an increase in non-performing loans to 4.06 percent in April from 3.2 percent at the end of 2008. It warned that many of these loans were the result of rapid lending growth averaging 20 percent per year over the past 5 years.

The loans, Moody’s said, were “underwritten using a risk management system that had not been tested in a crisis.”

“The current loan situation implies that 47 percent of loans were booked in the past three years,” the report said. “Moreover, many were granted under highly competitive terms. Moody’s is particularly concerned that these loans could become potential problems. Borrowers may become stressed when the interest rate cycle reverses and rates rise.”

Despite the fact that domestic banks were likely to face increasing pressures, particularly on asset quality, they would “fare relatively well as the country’s macroeconomic conditions slow.”

The ratings agency stressed that its outlook was contingent on global economic conditions stabilizing or improving.

Moody’s also said lenders’ earning might decline this year because of pressure on net interest margins, higher credit costs and falling fee-based income.

“Competition for deposits has further raised the cost of funds.” the report said. “In addition, a reversal of a declining rate cycle may further hurt margins for those banks which hold substantial amounts of fixed loans and government bonds.”

The agency added that fee-based income was likely to decrease on the back of the slowing economy. Fee-based income refers to charges collected by banks for services such as overdrafts and checking accounts.

Bank Indonesia has acknowledged the risk of increasing bad loans in the banking system due to uncertainties ahead, and has scaled back its lending expansion target to 11 percent to 12 percent for the full year.

Despite the recent increase in non-performing loans, the central bank says the banking sector remains stable, as shown by a robust average capital adequacy ratio of 17 percent and average NPL ratio of less than 5 percent. Capital adequacy ratio measures a bank’s capacity to withstand risks, with Bank Indonesia requiring a minimum CAR of 8 percent.

David Sumual, an economist at PT Bank Central Asia, disagreed with Moody’s outlook, which he said was based on out-of-date figures from April.

“If they look at the second-quarter results, the performance of the banking sector came in far beyond expectations, with profits soaring and NPLs declining.” he said. “NPLs reached their peak in April but have been decreasing since then.

Moody’s said in May that it was considering downgrading the deposit and subdebt ratings of Indonesian lenders on fears that the government might be unable to bail them out should a systemic threat to the banking sector arise.

At the time, the Indonesian Banks Association (Perbanas) said that agency should refrain from making pronouncements based on unfounded worries as they had potential to damage the economy.