Private Banks Adjust in Times of Distress

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SOCBs is estimated relative to the control group of similar private banks for our difference-in-differences estimation.

The LGD can be estimated based on the monetary value of all the adjustments that happen when a distress occurs. For SOCBs, we focus on the following five categories of adjustments: 1. Percent change in capital 2. Percent change in provisioning 3. Percent change in debt 4. Percent change in lending 5. Percent change in fixed assets (including sale of fixed assets).

To estimate the adjustment size for each of these five categories for distressed SOCBs relative to private banks, we regress each variable in categories 1–5 on the distress dummy, the interaction of the distress dummy with the SOCB dummy, and control variables—including bank and time fixed effects (see appendix 3A for a detailed description of the estimation methodology).

Overall Results, with a Focus on India

Our estimation results, summarized in figure 2.9, suggest that compared with distressed PVTBs (the control group), distressed SOCBs tend to adjust to distress by increasing capital relatively more than distressed PVTBs (see tables 2B.4 and 2B.5, in annex 2B, for detailed results). This finding could reflect the government’s efforts to promptly recapitalize at least systemically important public banks—most notably, India’s SBI. It can also reflect the softer budget constraints that SOCBs as a group enjoy compared with private banks. These softer budget constraints can then increase moral hazard among SOCBs and distort their incentives to properly manage credit and other risk taking, as well as act in a timely manner to restore their performance when it declines.

To a lesser extent, during the initial year of distress, SOCBs tend to increase fixed assets (invest)—or at least do not drop their plans to accumulate fixed assets. This result could be linked to the government capital injections that often come with the conditionality to continue supporting priority lending sectors and government programs and stimulate economic growth. If SOCBs are unable to stimulate growth through lending—for instance, because breaching prudential requirements can trigger regulations that prohibit increasing the lending portfolio—the SOCBs can use their investments to help stimulate growth and meet government conditions of recapitalization.

FiGURE 2.9 Differences in How State-Owned Commercial Banks and Domestically Owned Private Banks Adjust in Times of Distress

Capital

Debt

Lending

Investment

–4 –3 –2 –1 0 1 2 3 4 5 6

t statistic

PVTBs SOCBs

Source: Tables 2B.4 and 2B.5, in annex 2B; Kibuuka and Melecky 2020. Note: The bars depict the t statistics of the estimated adjustment coefficients. PVTBs = domestically owned private banks; SOCBs = state-owned commercial banks.

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Moreover, our estimation results show that distressed PVTBs tend to reduce lending significantly in the initial year of distress. Compared with distressed PVTBs, distressed SOCBs do not decrease their lending significantly in the initial year of distress. PVTBs do not appear to use other adjustment channels significantly. It may be more difficult and expensive for them to raise additional equity or borrow in times of distress; the estimation results for debt somewhat support this conjecture. Namely, PVTBs can somewhat reduce their debt financing during periods of distress compared with SOCBs, whose borrowing can be relatively less affected or even increase in periods of distress relative to PVTBs. Note, however, the possible offsetting results for distressed SOCBs’ debt across the contemporaneous and lagged PSB dummy (table 2B.4, panel b, column 2). With the disciplining pressure of difficult access to additional debt in times of distress in mind, PVTBs could be keeping larger buffers to draw on and serve as a cushion during episodes of distress—which could mitigate the likelihood of distress in the first place. (For instance, the capital adequacy ratio and net interest margins of PVTBs are higher than those of SOCBs; see table 2C.1, in annex 2C.) Also for this reason, PVTBs’ preferred adjustment channel can be to reduce lending to clients—both by a prior strategic choice and necessity in times of distress.

Our estimation results are robust to alternative threshold measures of distress (table 2B.5): namely, the ROA turning negative and the CRAR falling below 11 percent.15 During the initial year of distress, distressed SOCBs tend to increase capital when the ICR falls below 1, or profitability turns negative, or when the ROA turns negative. When CRAR falls below 11 percent, distressed SOCBs may also increase total capital, but this estimation result is not statistically significant. This may be the case because when CRAR levels reach around 11 percent, they still exceed prudential requirements of 9 percent; thus, SOCBs may opt to adjust in other ways than increasing capital.

Distressed private banks tend to increase provisions during the initial year of distress as well as the subsequent period as profitability turns negative. In contrast, distressed SOCBs do not seem to significantly increase these buffers during similar distress events because they appear to rely on capital infusions to address these issues. This difference in adjustment channels in the face of similar distress events could reflect the difference in governance in these banks—private banks rely on their own resources, while SOCBs rely on government resources to address the distress issue. The robustness checks broadly concur with the baseline results—although they are not as statistically significant (CRAR) or their timing is slightly different (ROA).

Regarding debt dynamics, distressed PVTBs reduce their debt borrowing in times of distress, while distressed SOCBs enjoy softer borrowing conditions than distressed PVTBs. The difference between SOCBs’ and PVTBs’ debt borrowings in times of distress could also relate to the prevailing type of debt instruments the banks use. SOCBs tend to borrow from public institutions and agencies such as the RBI, while PVTBs tend to access and are more exposed to foreign capital markets and their stricter covenants, and thus discipline.

Other significant results indicate that private banks reduce lending during the initial year of distress when their CRAR falls below 11 percent. Because these banks tend to maintain higher CRARs, they may prioritize building capital buffers over increasing lending when these ratios fall below 11 percent. In addition, because their income sources are more diversified relative to SOCBs, private banks can reduce lending without significantly affecting their income.

We now turn to fixed assets and investment dynamics during times of distress. Perhaps because PVTBs find it difficult to adjust investment plans in the near term, distressed PVTBs with a CRAR below 11 percent or negative profitability (ROA) tend to reduce investment in fixed assets only in the year following distress—compared with distressed SOCBs, which can sustain investment. The differences in adjustment by PVTBs and SOCBs when faced with a CRAR below 11 percent or negative profitability (ROA) further illustrate PVTBs’ focus on self-reliance compared with

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SOCBs, which enjoy softer budget constraints and backing by government capital to support their operations and survival. The self-reliance

of private banks versus potential moral hazard of SOCBs can severely undermine market discipline and the efficient functioning of financial markets.

In sum, sound SOCBs may help sustain lending to firms throughout the cycle and in the face of financial shocks. However, weaker SOCBs could fall into distress more often than private banks and reduce lending in times of distress compared with sound SOCBs. However, if private banks get into distress—including because of common macro shocks—they reduce lending much more than distressed SOCBs and even more so than sound SOCBs. Significantly reducing lending is the adjustment private banks select in times of their less frequent distress. SOCBs have softer budget constraints regarding both equity injections and additional debt borrowings. Compared with private banks, the softer budget constraint and conditions of government recapitalization (to help stimulate growth) could encourage SOCBs to sustain their investments (fixed asset accumulation) even when distressed. However, the soft budget constraints inflict substantial fiscal costs and erode discipline and competition in the financial market.

Broadening the Analysis to Include Bangladesh, Pakistan, and Sri Lanka

Can the adjustment patterns estimated for Indian banks be generalized to the three other main South Asian economies? To address this question, we ran the same estimations on a pool of data obtained from Fitch Connect for Bangladesh, India, Pakistan, and Sri Lanka. The timing of the data and the estimation variables were adjusted to better correspond with the fiscal year timing of the Prowess database for India. The estimation results are reported in table 2B.6, in annex 2B.

Our estimation results show that entering a period of distress, the capitalization of both SOCBs and private banks is declining. Unlike the Prowess data estimate, the Fitch Connect data estimates suggest that both private banks and SOCBs get recapitalized. The results by country reveal that the private bank recapitalization happens in Bangladesh, India, and Sri Lanka, but less so in Pakistan. SOCBs are also promptly recapitalized, most significantly in Bangladesh, less so in Pakistan, and least so in Sri Lanka. Although the recapitalization appears statistically more significant for private banks, it is almost three times larger for publics banks, on average. The same hypothesis and result for India of SOCBs having softer budget constraints than private banks are thus broadly confirmed for other main South Asian economies. Provisions are released by private banks after the distress event, while SOCBs do not release accumulated provisions—which could further confirm their greater reliance on new capital injections.

Lending by private banks declines significantly after the distress event, while SOCBs continue to increase lending. Again, the conditions of SOCB recapitalization may often require them to continue to stimulate the economy—and if not breaching prudential rules, increase their lending. This pattern is most significant in Bangladesh and less so in India and Pakistan. In Sri Lanka, SOCBs curtail lending after distress—even more so than private banks. This could relate back to low recapitalization of SOCBs in Sri Lanka and to their harder budget constraints relative to other SOCBs in the region. This result highlights the trade-off between increasing fiscal discipline through harder budget constraints and having SOCBs absorb risks and continue lending even when big shocks hit.

After episodes of distress, investments increase at SOCBs, while they decrease mildly at private banks. This finding could again reflect the conditions of recapitalization that require SOCBs to stimulate the economy. If such stimulation is not possible through increased lending because of prudential constraints, increasing fixed investments is another way to implement such stimulus. These results are consistent with the Prowess estimation for India. This pattern is also strongly evident in Bangladesh. By contrast, this investment stimulus of SOCBs in distress