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

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.