What Saved the Indian Banking System: State Ownership or State Guarantees?

Abstract

AbstractThe global financial crisis which began in the fall of 2007 and progressively worsened in 2008, affected the Indian financial sector beginning only in 2008. While Indian financial firms have been fairly resilient compared with their global counterparts, we show that Indian private sector firms faced greater losses compared with public sector firms during the crisis period of 2008–09. We use a stock market‐based measure of systemic risk, marginal expected shortfall (MES), to determine the systemic risk contributed by each Indian financial firm for the period preceding the crisis (January–December 2007) and compare it to its realised returns during the crisis (January 2008–February 2009). Our results show that public sector firms outperformed private sector firms despite having greater systemic risk during the crisis. We conclude that investors rewarded Indian public sector firms with greater systemic risk while penalising private sector firms with similar risk. We attribute this finding to the explicit and implicit government backing of public sector banks. We find that riskier public sector banks with high ex ante systemic risk and low Tier 1 capital received greater capital support from the government.