Indian banks and economic shocks

Amaresh Samantaraya | Updated on November 22, 2017

The Reserve Bank of India (RBI) headquarters in Mumbai. - Photo: Paul Noronha   -  BusinessLine

The RBI report concludes that macroeconomic shock will not seriously impact Indian banks. Yet, the central bank cannot abandon conservative practices.

The Reserve Bank (RBI) recently published its Second Financial Stability Report. The Report has flagged several items as important areas of concern. Some critical ones include deterioration in the balance of payments; regulatory gaps in the NBFC sector; putting in place a robust macro-prudential framework; domestic inflationary outlook; as also putting government finances back on the track in alignment with FRBM Act, 2003. Two noted columnists (both former senior executives of RBI) have already posted their comments in these columns. The article “Weak spots in the system” (January 12), stressed the need for meaningful action towards reducing risks to financial stability from the activities of NBFCs taking advantage of regulatory arbitrage, and the need for monitoring offshore banking units.

The article “Threats to financial stability' (January 14) suggested the need for modification in the liquidity adjustment facility so as to offset misalignment between banks' credit and deposit growth, urgent action to counter adverse developments in balance of payments and intervention in the forex market to align the exchange rate with the fundamentals.

The RBI assesses the impact of macro-economic stress factors on financial stability, and points to the resilience of the Indian banking system.


As regards credit risk, the Report observes that with doubling of the current non-performing assets (NPAs) there will be little deterioration in the capital to risk-weighted assets ratio (CRAR); but with an increase of NPAs by 300 per cent, CRAR of a set of banks accounting for 40 per cent of total assets would fall below 9 per cent, the regulatory limit. Thus, credit risk is stated not to be a significant cause of concern, except under extremely stressed conditions.

The above calculation of CRAR was undertaken under Basel I to avail of long historical data. Therefore, the above inference on credit risk assessment is also subject to variation in the CRAR requirement between Basel I and the latest prudential norm. Furthermore, as Dr. C. Rangarajan, the guru for many in RBI, used to say – CRAR in a way indicates minimum capital requirement but not necessarily adequate to cover credit risk.

Liquidity stress test results revealed that several commercial banks did not have adequate liquidity assets. The position of urban co-operative banks (UCBs) was better with liquid assets forming about 35.6 per cent of their total assets. This brings into consideration the utility of high SLR requirements to cushion liquidity risk in times of stress.


In the post-global financial crisis scenario, many analysts have underscored the need to incorporate macro-prudential concerns. It is highlighted that the economic cycle is a major source of homogenous behaviour and cannot be ignored in any analysis of financial stability.

The Report introduced an econometric analysis of the impact of macroeconomic shocks on the ratio of NPAs to total advances. From the empirical analysis, it was concluded that macroeconomic shocks would not substantially threaten the Indian banking sector.

As humbly noted in the Report, the model lays down the first steps towards putting in place an extensive macro stress-testing framework, although these would need some technical improvements.


Emphatically, the theory of animal spirits, borrowing from Nobel Laureate George A. Akerlof and Professor Robert J. Shiller, emphasises that the conventional explanation of the macroeconomy fails to take into account the euphoria followed by pessimism. This should caution the RBI's analysts before concluding that “the impact of shocks on macroeconomic variables constructed under various stress scenarios is found to be muted”.

Central bankers cannot afford to avoid conservatism. This virtue perhaps helped Dr Y.V. Reddy protect Indian banks from the fallout of the global financial crisis.

Published on January 21, 2011

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