Indian banks during 2007-09 crisis: public sector vs private sector banks

By Amol Agrawal

I came across this paper by Viral Acharya et al presented at the 7th NIPFP-DEA research program. This is a paper whose theme I have been wanting to read for a long time. Indian financial system largely escaped this crisis barring the 3-month liquidity crunch post Lehman. However, even in that time certain banks and financial system fared worse than others. There was a shift of household savings to bank fixed deposits and within banks to government banks. What does research show? Acharya et al show this interesting relationship. They calculate risk of individual banks before the crisis. They then club these banks as private and public sector banks. Next they see banks share prices in the time of the crisis. Their findings are:
1. In private sector , the banks which were seen as more risky before the crisis, their share

prices fell more in the time of the crisis. Even deposits contracted more for riskier banks. hence, risk works both ways.
2. In public sector, the trend is reversed. Public sector banks despite having higher risk

contribution, do not fall as much. Deposit growth too remains strong. Very contrarian findings. We associate PSBs with lower risks hence the stability. But the authors have a different story to tell. The paper uses a measure called Marginal Expected Shortfall (MES): Specifically, MES estimates the expected losses of a stock conditional on a crisis. Since extreme tail events such as a mild financial crisis happen once a decade and severe crisis such as the Great Depression or the Great Recession only one in several decades, the practical implementation of MES relies on normal tail events. We use the normal tail events as the worst 5% market outcomes at daily frequency over the pre-crisis period. In our analysis, we take the 5% worst days for the market returns as measured by the S&P CNX NIFTY index in any given measurement period, and then compute the negative of the average return for any given bank for these 5% worst days. The MES measure can also be interpreted as the contribution of each firm to the systemic risk in the event of a crisis. Need to read more on this MES measure explained in earlier Acharya et al paper. A variant of MES is $MES which multiplies MES with market cap of respective firms. Coming back to the paper. So via this MES, they estimate how different banks are placed on the risk front. In private sector they also look at housing finance companies and brokers as well. Broadly MES looks like this: Average MES value is higher for public sector banks (4.34%) compared to private sector banks (3.58%). That is, the public sector banks had on average negative 4.34% returns on the days the market return (S&P CNX NIFTY) was below its 5th percentile for the pre-crisis period from January 2007 to December 2007. India Infoline (6.99%), IFCI (6.80%) and Indiabulls financial services (6.44%) had the highest MES among the private sector financial firms. In the public sector, IDBI bank (6.67%), Union Bank of India (5.41%) and Dena Bank (5.23%) had the highest MES. Focusing next on $MES, in the public sector banks, State Bank of India had the highest $MES (Rs. 30 crores) whereas for private sector banks, ICICI had the highest $MES (Rs.

37 crores) as mentioned above. PSBs had a higher average $MES value (Rs. 396. crores) compared to the average $MES value of private sector banks (Rs. 225 crores). However, within private sector, banks have a high MES but the other private sector firms have a lower MES bringing the whole MEs lower for private sector. And then they look at how deposits and share prices fared in the crisis. The findings are Despite having higher MES, public sector banks fare much better compared to private sector. Within private sector there is wide divergence, but overall one sees a much higher decline despite having lower risk. From Mar-08 to Mar-09 public sector deposits grew by 24.1% vs 8% for private sector. Same is the trend for bank credit as well. So what are the lessons? Does it mean the public sector banks are better and India should slow down private sector banking? No, the authors say. The public sector banks had better performance not because of low risk profile but because of government support: We conjecture that the relative underperformance of private sector banks in the crisis in spite of their superior pre-crisis risk-return profile is instead attributable to the implicit and explicit sovereign backing of public sector banks. The Indian Bank Nationalization Act provides an explicit guarantee that all obligations of public sector banks will be fulfilled by the Indian government in the event of a failure. As a result of this guarantee, we hypothesize that during the crisis of 2008-2009 private sector banks experienced a loss of confidence and capital gravitated to PSBs even when their exposures to an economy-wide crisis were ex ante similar because investors believed that the PSBs would be bailed out by the government in the event of a failure. And that given this expectation, capital flew from the riskier private sector banks to the more stable public sector banks resulting in a decline in equity valuations of the private sector financial firms during the crisis. The authors show that PSBs which had higher MES also saw getting more capital infusion from the government. A significant part of fiscal stimulus in India was governments capital infusion in PSBs. The evidence in this section supports the hypothesis that the implicit and explicit government guarantees helped PSBs perform better during the crisis. The effect of the bailouts in end of 2008 on market sentiment towards PSBs versus private sector banks can be seen in Table 5. The quarter-by-quarter regressions of realized returns versus MES show that public sector firms had a high positive slope of 5.22 (t-stat 2.63) in Q4 2008: worst banks in terms of systemic risk exposure fared better in this quarter. Compared to this, private sector firms had a negative slope of -1.42 (t-stat 0.95). Hence, the implication is not to go slow on private sector banking. Though, public sector and governments role help in crisis, it leads to crowding out of private sector in the long run. Also going by experiences of Fannie/Freddie in US, it is dangerous to keep giving explicit and implicit government support and guarantees. It leads to build up of complacency which leads to higher risks and trouble in future. Superb paper for the wide breadth of issues it covers. It looks at so many aspects and is a very interesting read for its simple writing. It is pretty balanced as it highlights both strengths and weaknesses of an Asian banking model with public and private sector banks. Having said that, whatever model of banking you choose it is difficult to escape financial crises. To think having more public sector or private sector banks will help, is too simplistic. Asian

banks escaped as they were more conservative and did not go as wild as their foreign counterparts. Till this crisis, the world view had heavily tilted towards private sector banks. But after this crisis, we know both are much the same as both end up being saved by the government. This point needs to be highlighted. Though, the Indian government capitalised PSBs, it helped private sector banks as well as it is a massive network of firms and transactions. Even if one Indian bank was found to be weak and not supported, it could have taken the system with it. Similar thoughts were applied to bailouts and infusions in other economies as well. Save a few and it will help the system as a whole.

http://mostlyeconomics.wordpress.com/2010/12/13/indian-banks-during-2007-09crisis-public-sector-vs-private-sector-banks/