Macroeconomic Determinants of Asset Quality of Indian Public Sector Banks: A Recursive VAR Approach

This paper undertakes a Macro Prudential Analysis (MPA) of credit risk, the predominant risk category of Indian Public Sector Banks (PSBs). Assuming bank-specific shocks to be nil at the micro level, the paper employs a recursive Vector Auto-Regression (VAR) methodology to examine the transmission of shocks from major macroeconomic variables on the default rate of banks. The VAR model is applied to monthly data from the period 1994-2003. This is the first attempt in the Indian context that studies the links between asset quality and macroeconomic shocks using the VAR model. There is no evidence of cyclicality and procyclicality at one month lag as revealed by Granger causality tests. However Impulse Response Functions reveal the existence of cyclical and procyclical patterns over two months. Further shocks to exchange rate and monetary policy significantly affect bank asset quality. The implication of this study is that with the forthcoming Fuller Capital Account Convertibility (FCAC), banking sector in India is likely to be under increased stress in view of the exchange rate volatility and consequent rise in interest rates. In this scenario monetary policy emerges as an important precondition for banking stability. It may be suggested that the authorities need to take a balanced overview of financial stability in aggregate rather than focusing on price stability alone.