Stability Analysis of the Financial Systems

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Title

Stability Analysis of the Financial Systems of Pakistan and India

Abstract

The objectives of this study are to assess the state of stability of the Banking systems of Pakistan and India and then to estimate how good, bad and worst economic conditions would influence its state of stability. Our design of study is a mix of the techniques used by independent analysts and financial system regulators. The model used in stress testing and scenario analysis are employed but in simplified form. Pakistan and India have not experienced financial crisis due to some shock/contagion,therefore stress events and its impact on macroeconomic indicators are not included in the design. Determinants of asset quality of commercial banks are determined and its influence on Nonperforming Loans (NPL) ratio explored empirically. A bank is termed unstable if its estimated Nonperforming Loans/advance ratio surpasses its equity/advance ratio during a year in a scenario. Scenarios of good, bad and worst economic conditions are developed for stress testing on the basis of extreme values of macroeconomic variables during sample period. Stability of whole banking system during a year in a scenario condition is evaluated on the basis of assets controlled by banks estimated unstable. First we take stock of banking system of Pakistan. During 1998-2001, in normal, bad and worst economic conditions, banks assessed significantly unstable are in control of maximum 35%, 50% and 62% assets respectively of the whole banking system. During 2002 and onward banks assessed significantly unstable are in control of maximum 6% assets of the whole banking system in normal, bad and even worst economic conditions. Thus it can be concluded that Pakistani banking system is stable since 2002 and can withstand bad and even worst economic conditions. As far as Indian banking system is concerned, Citibank (foreign bank) is the only bank appraised stable after 2006 and also adjudged able to withstand even the worst economic conditions. Almost all public sector banks reviewed are assessed unstable during 1999-2005. They exhibited signs of recovery during 2006-2011 but adjudged markedly unstable during 2012-14. During 2014, twelve (out of total thirteen) public sector banks are evaluated significantly unstable in bad economic conditions. The three private sector banks i.e. Axis, HDFC and ICICI are evaluated to have performed satisfactorily specially during the last four years of the period under review. The instability of the Indian banking system in 2014 is more noteworthy when six banks possessing 30% assets of the banking system are appraised unstable by significant margin. The number of banks adjudged significantly unstable is (maximum) two during 1999-2013 but abruptly increases to six in 2014. Results of the stress testing of the banking system of India under various scenarios denote that Indian banking system lacks the potential to withstand any macroeconomic shocks. In any significant adverse macroeconomic conditions, the system is expected to collapse.

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