Stress Test of Banks in India Across Ownerships: A VAR Approach

Abstract

This paper examines whether the Indian banking system is robust to withstand unexpected shocks from external and domestic macroeconomic factors. Demirguc et al (1998) Kaminsky et al (1999) demonstrate that banking crisis follow financial liberalization. India embarked financial deregulation from 1992 whereas the ongoing global financial crisis (GFC) could jeopardize bank portfolios. Stress-test is undertaken through the Vector Auto Regressive (VAR) model to examine if decline in GDP, exchange rate volatility and foreign capital portfolio funds adversely impact bank asset quality through higher defaults. VAR model is run for banks belonging to public, private and foreign ownerships. Banks’ soundness is measured by the non-performing assets (NPA) with quarterly data from 1997 to 2014. Our contribution lies in finding that there is little divergence among the banks of different ownerships in their response to the shocks from real effective exchange rate, capital flows and GDP output gap. IRF shows that GDP shock to NPA of public and private banks take more than 9 and 8 quarters to stabilize. The shock from Net Foreign Institutional Investment to private banks NPAs take 8 lags. Foreign banks are impacted by the same macroeconomic factors. The stress test exhibits that public banks are more vulnerable and need re-capitalization. We also demonstrate that the domestic banks are not adversely affected by the GFC credit for this could be attributed to the well calibrated regulatory policies of the RBI. Although foreign banks may have suffered setbacks, it is not captured in our analysis.