Dynamic Interaction of Bank Risk Exposures: An Empirical Study for the Indian Banking Industry

Abstract

Banks are exposed to different types of risks in the process of financial intermediation and maturity transformation. The experience of the extant global financial crisis provided ample evidence of interaction among bank risks and perils of ignoring interactions in the changing economic, technological and regulatory environment. In this study, we assess the dynamic interaction among bank risks for the entire banking sector and bank groups based on various bank-specific characteristics in a vector autoregression framework, including variance decomposition and impulse response function analysis. We estimate the market measures of different risks using a multivariate GARCH (1, 1) in mean model. The study uses weekly bank level data from 23 October 2004 to 1 August 2014 for 40 listed Indian banks. The findings suggest that there is a positive interaction between equity risk and all other risks. Credit risk and exchange rate risk have a reciprocal relationship. It has also been observed that equity risk impacts credit risk positively. Interest rate risk seems to be affected by its lagged values and does not appear to be affected by other risks. The study highlights the role of liquidity in reducing bank risk exposures and supports new liquidity standards introduced in Basel III. The results improve the understanding of the interaction among risk exposures, which may enhance the supervisory process in the Basel framework. The risk interactions must be kept in mind for making capital provisioning, and an integrated approach to risk management by banks is more desirable.