Banking Sector Reform and Insolvency Risk of Commercial Banks in India

The paper analyzes the insolvency risk of commercial banks in India for the period 1998-2007. This has primarily been motivated by the changes in the structure and conduct consequent upon the banking sector reforms which have gradually brought the much-desired dynamic and competitive forces into the system that enabled banks to perform better by way of flexibility in their operations and diversification into organic and inorganic lines of business, notwithstanding the market-induced vulnerabilities. Though reforms have facilitated reduction in cost of deposits and cost of funds across all bank groups and improvement in the return on assets, facilitated by higher spread and lower burden, nonetheless, there is persistence of significant disparity among banks in their conduct, performance, cost minimization and on the risk management front. Using ‘Z-score’ measure of insolvency risk and panel data econometrics, it is found that the Indian private banks are most risky, whereas the foreign banks are found to be least risky for their fat capital cushion. The Public Sector Banks (PSBs) are in the intermediate category in terms of their risk levels. Further, higher competition tends to induce risk unless there are efficiency improvements across the banks. Diversification is also found to have a risk-mitigating effect; however, diversification per se is not sufficient condition for lowering the risk; rather, selective diversification coupled with buffer capital could yield the sufficient condition for banks’ safety. While the banks have adapted themselves to the changing environment, the fast evolving financial landscape continues to pose several challenges. Therefore, banking regulation assumes increasing significance in these changing environments for adequate assessment of risk and to discourage risky behavior.