Despite IL&FS collapse, no evidence of systemic risks yet

Persistent bad loans and NBFC crisis may have aggravated India’s economic downturn since late 2018, but a new RBI paper found little or no systemic impact, at least until May, 2019. History tells us that failure of a dominant institution can cause systemic damage, but IL&FS’ collapse and its impact clearly is yet to be scientifically documented and proven. 

Titled Measuring Financial Stress in India, the authors while identifying past financial stress using 11 market indicators like money, debt, equity, forex and banking sector data, found that systemic stress was decidedly visible only during Q3, FY09.

Episodes of stress together with six consecutive months of real economic stress are deemed systemic. Though there were months when financial stress was above acceptable thresholds, the composite index saw only three episodes that accompanied a prolonged decline in real economic activity. First was between June, 2008 and May, 2009 followed by September, 2011-January, 2012 and from July-September 2013, with systemic stress visible only during Q3, FY09. 

Individual Financial Sector Index (FSI) for money, equity, debt, forex markets and others showed the highest level of stress first in October, 2008 during the global financial crisis, followed by August-September, 2013 during the US taper tantrum. Interestingly, even the banking sector’s FSI peak stress was seen during the same period and much less after the NPA clean-up exercise starting 2016.

Monitoring financial stress using an index gained momentum after the 2008 global financial crisis. The US constructed 3 different FSIs for 3 regional Federal Reserve Banks during 2009-2011 based on 11 variables available at monthly frequency. Finland measured its financial system instability with 14 indicators, while Turkey combined data from exchanges, bond market, banking sector, and external sector.

The Euro area has a composite indicator of systemic stress based on six variables and the index is used as an early warning indicator to assess the impact of the financial stress on the real economy. Globally, central banks measure financial stress using FSI to gauge systemic risks and the probability of occurrence of stress events.

But in India, this approach is scant and limited, the authors noted though compared to balance sheet and macroeconomic variables, financial market-based indicators are available on a real-time basis at higher frequency, making them more useful for constructing FSIs.

For instance, the Mumbai interbank offered rate (Mibor), the benchmark interest rate at which banks borrow funds from the interbank market and announced daily is likely to exhibit the first signs of financial stress. Similarly, TED spread calculated as the difference between the 3-month Mibor and the 3-month Treasury Bill, or the spread between risky and safe assets, reflects the flight to quality implying a decline in investors’ willingness to hold risky assets.