Resilience of Indian banks: Macroeconomic stress test modeling for credit risk

• Published date: 01 February 2022
• Author: Biswajit Patra,Puja Padhi
• Date: 01 February 2022
• DOI: http://doi.org/10.1002/pa.2350

ACADEMIC PAPER

Resilience of Indian banks: Macroeconomic stress test

modeling for credit risk

Biswajit Patra | Puja Padhi

Department of Humanities and Social

Sciences, Indian Institute of Technology

Bombay, Mumbai, India

Correspondence

Biswajit Patra, Department of Humanities and

Social Sciences, Indian Institute of Technology

Bombay, Mumbai, India.

Email: bpatra55@gmail.com, biswajit_patra@

iitb.ac.in

The macro stress testing is an integral part of the credit risk management exercise to

judge the strength of banks in hypothetical stress situations. The present paper

develops the macroeconomic stress testing model and checks the resilience of banks

across different groups of banks in India like the public sector, private, and foreign

banks in maintaining the minimum required regulatory capital at the time of stress situa-

tions. The stress testing exercise is undertaken by the use of panel data models to eval-

uate the impact of likely changes in macro parameters on the non-performing loans

under three stress scenarios like baseline, medium, and severe. The impact of these

stress testing is substantial for the public sector banks as compared to private and for-

eign banks. Except for the few banks, all other public sector banks are not able to sus-

tain the macro stress scenarios and became insolvent. In opposite to this, all the foreign

banks are able to sustain all the stress scenarios. The private banks are also able to with-

stand the assumed crisis, except few banks failed to do so. The study may be useful for

studying the preparedness of banks to face the crisis period and also helps them to get

themselvesequipped with the requiredcapital to meet those circumstan ces.

JEL CLASSIFICATION

G21; H81; C23

1|INTRODUCTION

The stress testing is used for accessing the resilence for different types of

risks such as credit risk, market risk, operational risk, interest rate risk, and

liquidity risk. The credit risk is considered as the major risk for Indian

banks since more than 70% of bank assets are in the form of loans. The

macro stress testing (MST) is a credit risk management tool used by banks

across the globe to check the resilience of the banking system. In the

MST process, the weak but plausible macro situations lead to a rise in

credit risk. Further, the strength of banks is tested to comply with

required regulatory capital in the presence of rising credit risk. Several

studies discussed the macro stress testing exercise for credit risk of banks

both within India and outside India (e.g., Dua & Kapur, 2018; Kanas &

Molyneux, 2018; Onder, Damar, & Hekimoglu, 2016; Vazquez, Tabak, &

Souto, 2012). The solvency of Madagascar banking sector is studied by

the capital adequacy situation of the banks due to macroeconomic shocks

(Rakotonirainy, Razafindravonona, & Rasolomanana, 2020). It explains

how different levels of macro stress scenarios impact the non-performing

loans (NPLs) of banks and further the impact of rising NPLs on the capital

level of banks (Ghosh, Ahmed, & Khan, 2020; Mohammed &

Onour, 2020). However, the topic is less discussed in Indian literature. It

is observed that there is no such significant study to check the strength

of the individual banks across different groups in the Indian banking sys-

tem to monitor sustainability at different macro stress scenarios. The pre-

sent paper noted to have different results from the existing literature that

the banks in India are not prone to macroeconomic shocks (Dua &

Kapur, 2018).

Banks in India are categorized into different groups depending

upon their ownership structure and operations, such as public sector

banks (PSBs), private sector banks (PVBs), and foreign banks (FBs).

Presently, these banks, particularly the PSBs, are going through a

phase of a downturn due to the piling of bad assets (Figure 1).

The study aims to build up forward-looking scenarios at various

severities such as baseline, medium, and severe for the Indian banking

industry to face the crisis and checking up the sustainability at that

crisis period. The present study is unique in the sense that it tries to

Received: 31 May 2020 Revised: 16 July 2020 Accepted: 1 August 2020

DOI: 10.1002/pa.2350

J Public Affairs. 2022;22:e2350. wileyonlinelibrary.com/journal/pa © 2020 John Wiley & Sons Ltd 1of14

https://doi.org/10.1002/pa.2350