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Macroeconomic Stress Testing and the Resilience of the Indian Banking System: A Focus on Credit Risk

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  • Niyogi Sinha Roy, Tanima
  • Bhattacharya, Basabi

Abstract

The paper undertakes a macroprudential analysis of the credit risk of Public Sector Banks during the liberalization period. Using the Vector Autoregression methodology, the paper investigates the dynamic impact of changes in the macroeconomic variables on the default rate, the Financial Stability Indicator of banks by simulating interactions among all the variables included in the model. Feedback effects from the banking sector to the real economy are also estimated. The impact of variations in different Monetary Policy Instruments such as Bank Rate, Repo Rate and Reverse Repo Rate on the asset quality of banks is examined using three alternative baseline models. Impulse Response Functions of the estimated models are augmented by conducting sensitivity and scenario stress testing exercises to assess the banking sector’s vulnerability to credit risk in the face of hypothetically generated adverse macroeconomic shocks. Results indicate the absence of cyclicality and pro-cyclicality of the default rate. Adverse shocks to output gap, Real Effective Exchange Rate appreciation above its trend value, inflation rate and policy-induced monetary tightening significantly affect bank asset quality. Of the three policy rates, Bank Rate affects bank soundness with a lag and is more persistent while the two short-term rates impact default rate instantaneously but is much less persistent. Scenario stress tests reveal default rate of Public Sector Banks could increase on an average from 4% to 7% depending on the type of hypothetical macroeconomic scenario generated. An average buffer capital of 3% accumulated during the period under consideration could thus be inadequate for nearly twice the amount of Non-Performing Assets generated if macroeconomic conditions worsened. An important policy implication of the paper is that as the Indian economy moves gradually to Full Capital Account Convertibility, the banking sector is likely to come under increased stress in view of the exchange rate volatility with adverse repercussions on interest rates and bank default rates. In this emerging scenario, monetary policy stance thus emerges as an important precondition for banking stability. The study also highlights the inadequacy of existing capital reserves should macroeconomic conditions deteriorate and the urgency to strengthen the buffer capital position.

Suggested Citation

  • Niyogi Sinha Roy, Tanima & Bhattacharya, Basabi, 2011. "Macroeconomic Stress Testing and the Resilience of the Indian Banking System: A Focus on Credit Risk," MPRA Paper 30263, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:30263
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    File URL: https://mpra.ub.uni-muenchen.de/30263/1/MPRA_paper_30263.pdf
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    References listed on IDEAS

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    1. Glenn Hoggarth & Steffen Sorensen & Lea Zicchino, 2005. "Stress tests of UK banks using a VAR approach," Bank of England working papers 282, Bank of England.
    2. Ivan Baboucek & Martin Jancar, 2005. "Effects of Macroeconomic Shocks to the Quality of the Aggregate Loan Portfolio," Working Papers 2005/01, Czech National Bank, Research Department.
    3. Carmen M. Reinhart & Graciela L. Kaminsky, 1999. "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems," American Economic Review, American Economic Association, vol. 89(3), pages 473-500, June.
    4. Pesaran, H. Hashem & Shin, Yongcheol, 1998. "Generalized impulse response analysis in linear multivariate models," Economics Letters, Elsevier, vol. 58(1), pages 17-29, January.
    5. Amadou N Sy, 2007. "Capital Account Convertibility and Risk Management in India," IMF Working Papers 07/251, International Monetary Fund.
    6. Marcucci, Juri & Quagliariello, Mario, 2008. "Is bank portfolio riskiness procyclical: Evidence from Italy using a vector autoregression," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 18(1), pages 46-63, February.
    7. De Graeve, Ferre & Kick, Thomas, 2008. "Monetary policy and bank distress: an integrated micro-macro approach," Discussion Paper Series 2: Banking and Financial Studies 2008,03, Deutsche Bundesbank.
    8. Daniel C. Hardy & Ceyla Pazarbasioglu, 1999. "Determinants and Leading Indicators of Banking Crises: Further Evidence," IMF Staff Papers, Palgrave Macmillan, vol. 46(3), pages 1-1.
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    Cited by:

    1. repec:eee:jpolmo:v:40:y:2018:i:2:p:452-475 is not listed on IDEAS
    2. Saikat Ghosh Roy, 2014. "Determinants of Non-Performing Assets in India - Panel Regression," Eurasian Journal of Economics and Finance, Eurasian Publications, vol. 2(3), pages 69-78.

    More about this item

    Keywords

    Banks; Macro Prudential analysis; Stress test;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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