RBI: Financial shocks and the Indian business cycle outcomes

The Reserve Bank of India on 24^th May 2021 released on its website its study titled, “Risk Premium Shocks and Business Cycle Outcomes in India”. The study was co-authored by Dr. Shesadri Banerjee, Shri Jibin Jose, and Shri Radheshyam Verma, all scholarly economists from RBI.

This study investigates the dynamic effects of financial shocks on the business cycle. Against the backdrop of high non-performing assets (NPAs) of banks, a financial shock is conceived to be a shock to the interest rate spread resulting from a change in the default risk of borrowers. Termed as the risk premium shock, this occupies the central stage in this study. Thereafter business cycle implications of such a shock have been explained in details.

Let me assure you that the whole research paper will be explained for your intellectual utopia in a simple language. Experts are requested to read the whole project paper thoroughly to understand the new line of thinking to interpret Indian economic scene.

The study elongates 68 pages spread over 7 chapters with the 8^th one being 8.1 – 8.8 appendices. Yes, being a serious research paper, slow and steady understanding of economy and the banking developments are expected from enlightened readers.

This study contributes to this evolving field empirically by evaluating the effects of financial shocks, emanating from financial intermediaries, like banks on real economic outcomes. Such an exercise is significant at least on two counts: first, financial intermediaries such as banks play a pivotal role in the economic landscape of developing countries, and not much attempt had been made in past to study this angle in a country like India.

 Second, understanding the sources of financial shocks to the banking sector and the possible mitigating mechanisms will be imperative for the conduct of monetary and fiscal policies and for ensuring financial stability. The authors feel that this study would help Government of India and RBI in their efforts to improve Indian economy.

Now to a valid question why among financial sector banking occupies a coveted position as a shock giver?

Let us recollect the economic scene in India during 2006-2011 when the economic growth was strong and previous infrastructure projects (e.g., power plants) were completed on time during this period of exuberance, banks also accepted highly leveraged projects with less promoter equity, extrapolating past growth and performance into the future at a time when banking sector occupied a central position in the macro-financial environment and occupied about 64 per cent of the total assets of the financial system.

Equally true was this information at that period that bank lending to industrial sector grew at an average rate of more than 20 per cent, which was far more than the nominal growth of the industrial sector.

In India, the banking sector has taken a central position in the macro-financial environment and occupies about 64 per cent of the total assets of the financial system.

The Indian banking sector has been going through troubled times weighed down by the overhang of stressed assets and the subsequent decline in profitability post 2011.

It is observed that stability of the banking sector, measured by Z-score, declined as non-performing assets (NPAs) shot up. Furthermore, macro-financial linkages – the standard co-movements between real and financial variables – appeared to have deteriorated during the period of financial stress. These developments – over and above the motives described earlier – prompt us to examine the financial disturbances in the banking sector.

But a lingering doubt exists. What has the disturbances in financial sector got to do with business cycles? Is it a global phenomenon and whether recent global crisis in banking in 2008-09 helped us to understand better?

Let me narrate the study from macro-finance literature at a global scale, particularly after the global financial crisis (GFC) of 2008-2009. Yes, global banking rattled the asset price valuations on the real economy and educated one about the value of financial system as an amplifier as well as the source of shocks.

Let us understand how the study of RBI would proceed to explain the role of financial sector on business cycle and what samples would help them to understand the facts.

The influence of financial shocks on business cycle fluctuations and the channels through which such shocks transmit had been at the core of macro-finance literature, especially after the global financial crisis (GFC) of 2008-2009. Though this global crisis did not touch India, the lateral developments like excessive lending by public sector banks which can be traced back to the excessive credit growth during 2006-2011 had led to challenges due to the high proportion of impaired assets, weak capital position, rising provisioning requirements, low or negative profitability and decelerating credit growth over the last few years

Let me introduce you to both the micro as well macro level studies.

Micro level analysis

At micro-level analysis, the study investigated the responsiveness of interest rate spread and growth of bank credit to the change in the default risk. A panel estimation using bank-level annual data for the sample period 2009 to 2018 pertaining to a panel of 55 Indian banks, including both private and public sector banks was used.

The authors used interest rate spread to measure the risk premium and the gross non-performing assets (GNPA) ratio as a proxy for the default risk of the borrower. An estimate was made of the relationships between (i) spread and GNPA ratio, and (ii) real credit growth and GNPA ratio using the dynamic panel models. Results of panel estimation showed that the rise of default risk increased interest rate spread and reduced real credit growth.

For the macro-level analysis, RBI researchers employed the SRVAR framework over the sample period 2002:Q2 to 2017:Q4; and used agnostic identification procedures based on the penalty function approach of Uhlig (2005) and the multiple shock identification approach of Arias et al. (2014).

 While the former offered partial identification of the structural shock, the latter provided a more robust approach to isolate the shock of interest by discriminating it from other possible structural and policy shocks. They ran several identification schemes of sign restrictions for both the approaches to check the consistency and robustness of their results.

 They also examined the forecast error variance decomposition (FEVD) and historical decomposition of the macro-financial variables with respect to the structural shocks. Additionally, they undertook a comparison of shocks obtained from the two SRVAR methodologies.

For a serious student of economics or banking with our regulatory authority RBI as the goal for study, it is important to see how the research was undertaken which is reflected in the following discussion.

Let me narrate the list of chapters which show research activities:

• Understanding the effects of risk premium shock to banking sector using sign-restricted VAR (SRVAR) model – chapter 4
• Examining the alternative forms of financial shocks and efficacy of policy interventions

Chapter 5

• Some of the tables containing wealth of data which helped the research are also given below
• Table 1: Comparing financial indicators in India and EME group
• Table 2: Changing pattern of macro-financial linkages over business cycles
• Table 3: Interest rate spread and GNPA – Dynamic panel estimation models
• Table 4: Real credit growth and GNPA – Dynamic panel estimation models
• Table 5: Sign restrictions for identification of risk premium shock
• Table 6: Identification of risk premium shock under Arias et al. Approach (2014) – Scheme 1
• Table 7: Alternative identification under Arias et al. Approach (2014) – Scheme 2
• Table 8: Alternative identification under Arias et al. Approach (2014) – Scheme 3
• Table 9: FEVD results from baseline model under Penalty function approach
• Table 10: Comparing peak effect of contraction for different identification schemes
• Table 11: FEVD results from baseline model under multiple shock identification approach
• Table 12: Baseline for policy simulation – Identification scheme
• Table 15: Recovery by credit easing policy – Identification scheme
• Table 16: Recovery by expansionary fiscal policy – Identification scheme
• Table 17: Recovery by expansionary policy-mix – Identification scheme
• Table 18: Comparing effects of risk premium shock under alternative policy responses

Based on data shown above in table 1 – 18,  Figure 1- 16B were drawn using complicated mathematical formulations by researchers. Only these figures interpreted scientifically enabled the researchers to reach their conclusions and us, easy explanation of the slow down of banking after a successful run till 2011.

Names of figure 1-18 from research are given below:

• Figure 1: Bank group-wise GNPA ratio, Figure 2: Bank group-wise credit growth, Figure 3: Nexus between credit channel and stability of banking sector, Figure 4: Real credit growth, Figure 5: Interest rate spread, Figure 6: GNPA ratio, Figure 7: Scatter plot of interest rate spread and GNPA ratio, Figure 8: Scatter plot of real credit growth and GNPA ratio.
• Figure 9: Macro-financial data indicators for SRVAR analysis, Figure 10: Effects of risk premium shock under Penalty function approach – Baseline Model, Figure 11: Effects of risk premium shock under multiple shock identification approach – Scheme 1, Figure 12A: Comparison of median IRFs across alternative identification schemes under multiple shock identification approach, Figure 12B: Comparison of median IRFs across alternative identification schemes under multiple shock identification approach.
• Figure 13: Historical decomposition by shocks from baseline model, Figure 14: Shock comparison between alternative SRVAR modelling, Figure 15: Historical decomposition of alternative financial shocks, Figure 16A: Comparison of output effects of risk premium shock under alternative policy interventions, Figure 16B: Comparison of inflationary effects of risk premium shock under alternative policy interventions.

Even a cursory glance of names of tables and figures indicate the flow of the research from micro financial indicators to macro level indicators like comparison of inflationary effects of risk premium shock under alternative policy interventions.

What does the research of RBI economists conclude ?

Conclusion of the study

Using both micro and macro-level analysis in this study , the researchers explored alternative policy interventions to mitigate the adverse effects of a risk premium shock on the economy. In the micro-level analysis, it was found that the interest rate spread, attributed to risk premium on loans, increased in response to a rise in loan defaults during the post2009 period. Also, credit growth was found to be negatively associated with the loan default rate, indicating that a shock to the borrowing sectors had a significant negative impact on credit growth.

Premised on the micro-level observation, the macro-level analysis suggested that a financial disturbance like a risk premium shock could be one of the major sources of credit and business cycle fluctuations in India. More specifically, SRVAR results under the penalty function approach suggested that a positive shock to risk premium led to an uptick in interest rate spread and a decline in bank credit and real price of capital goods. The contractionary impact was also visible from the real sector variables such as output, consumption and investment.

However, the effect of coordination between the monetary and macro-prudential policies to tackle the financial shocks in the banking sector was not addressed in this study.

My concluding observations

Though one of the most complicated economic research projects from RBI, our regulators, for the first time in my professional life, I was explained by top level economists the effect of financial shocks on Indian business cycle which was witnessed very recently. Most of us have read business cycle as a chapter in Economic text book but here, we are led step by step to understand them with examples from our own nation. I appreciate the enormous efforts of brilliant economists from RBI who have led us from ignorance to illumination in Indian economy. I do request the economists to study the effects of monetary and macro-prudential policies to tackle the financial shocks in the banking sector in India.

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