Stress test of banks in India across ownerships: a VAR approach

Abstract

Purpose This paper aims to examine whether the Indian banking system is robust to withstand unexpected shocks from external and domestic macroeconomic factors after financial liberalization in 1992. As proposed by Demirgüç-Kunt and Detragiache (1998) and Kaminsky and Reinhart (1999) banking crisis follows financial liberalization. India embarked financial deregulation from 1992, whereas the ongoing global financial crisis (GFC) could jeopardize bank portfolios. Design/methodology/approach 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. The VAR model is run for banks belonging to public, private or foreign ownership. Soundness of banks is measured by the non-performing assets (NPAs) with quarterly data from 1997 to 2014. Post-VAR estimation technique, Granger causality test (GC) and impulse response function (IRF) are used to check for robustness of the VAR model findings. Findings The authors found that there is little divergence among banks of different ownership in responding to the shocks from REER, foreign capital flows and GDP output gap. IRF shows that GDP shock to NPA of public and private banks takes more than nine and eight quarters to stabilize. Foreign banks are impacted by the same macroeconomic factors. The stress test exhibits that public banks are more vulnerable and need recapitalization. Moreover, domestic banks are not adversely affected by the GFC, and credit for this could be attributed to the Reserve Bank of India’s (RBI’s) regulatory policy. Research limitations/implications Surprisingly, capital market indices do not influence banks’ NPA, and this needs further investigation. The limitation arises from the fact that stock market index for banks was launched only in the early 2000. Missing data and limited number of banks shares traded in the market could explain the trivial results. Practical implications Findings of this study will be useful to RBI policymakers and bank managers. The exchange-rate risk faced by borrowers that lead to increased NPAs is an issue that the RBI would be interested to examine. The impact of foreign capital flows, adversely influencing the NPAs of banks, is a significant issue that the RBI is concerned with. Social implications Banking sector crisis has serious repercussions, causing loss of household savings and decline in confidence in the banking sector. Originality/value This topic was explored in India only by Bhattacharya and Roy in (2008). No other similar work has been done to the authors’ knowledge in stress test of banks in India across different ownership. The authors’ study period covers the GFC and shows that it has not caused devastation as it has in developed countries.