Understanding Bank Distress and Its Main Factors

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banks may reflect returns commensurate with their greater risk taking, as well as their greater capacity to manage credit risk (lower median NPL ratios). Finally, the solvency standing (regulatory capital ratio) and two broader measures of distress based on balance sheet solvency (z-score) and cash flows (ICR) suggest greater resilience of private banks to risk.

Nevertheless, caution is warranted in interpreting aggregate median numbers for the region. The situation can vary considerably across countries and within countries across individual banks. For instance, risk taking is lower than the regional median for SOCBs in Pakistan and even more so for SOCBs in Sri Lanka, with median ratios of riskweighted assets to total assets of 51 percent and 47 percent, respectively, compared with the regional median of 59 percent for SOCBs and 70 percent for private banks. In contrast, SOCBs in Bangladesh are the least profitable of the SOCBs in the region, based on the median statistics for the return on equity—3.6 percent for Bangladesh compared with 9.3 percent for the regional average (median). Indian SOCBs appear to sit comfortably around the median for the region on all considered SOCB characteristics except the ICR. Indian SOCBs, with a median ICR of 0.57, fall well below the regional median of 0.66. In none of the four major South Asian countries does the median ICR for SOCBs stand above 1. At the 75th percentile, the better performing SOCBs have ICRs well above 1 in Bangladesh, Pakistan, and Sri Lanka. However, India’s better performing SOCBs still fail to cross the threshold—possibly indicating systemic distress in the sector from 2009 to 2018.

Recent literature argues that bank distress can arise because the firms and households that banks serve are in distress. For instance, uncertainty about economic policy can boost the default risk of both firms and households, which is then transmitted to banks (Ashraf and Shen 2019; Gopalakrishnan and Mohapatra 2019). The literature also highlights the possibility that governmentowned banks may engage in adverse selection of borrowers (“reverse cherry-picking”). For example, firms that maintain exclusive relationships with governmentowned banks can enjoy privileged borrowing status with those banks: that is, the firms’ sensitivity of investment to cash flows (their financing constraints) is lower. But such firms can be in worse financial condition relative to other firms—for instance, be more leveraged, invest less, be less profitable, and have worse growth prospects (Srinivasan and Thampy 2017). Such adverse selection of borrowers can increase the default risk of government-owned banks because they lend to weaker firms on average.

For this reason, we also controlled for characteristics of client firms by linking banks to firms. For each bank, we constructed a client firm portfolio and calculated average characteristics of this portfolio, such as average firm size (total assets); leverage (debt-toequity ratio); investment orientation (investments to assets); and profitability (return on assets). Because of data availability constraints, we controlled for client firm characteristics only for Indian banks. The main characteristics of the client firms of PVTBs and SOCBs are summarized in figure 2.7. Detailed summary statistics, along with statistical tests of difference in average characteristics, are reported in table 2C.6, in annex 2C. The statistics suggest that client firms of SOCBs could be much less profitable, more leveraged, and perhaps bigger—reflecting the findings of the recent literature. However, these median characteristics of banks’ client firms mask significant variations. Therefore, the statistical test of difference between client firm characteristics of SOCBs and private banks shows that only leverage differs. That is, client firms of SOCBs are significantly more leveraged.

Conceptually, our econometric framework builds on the value at risk (VaR) methodology. It examines two types of losses. The first is the financial loss that could be passed on