An increase in the default risk, which is captured by the gross non-performing assets ratio (GNPA), increases the interest rate differential and reduces real credit growth. This emerges from a panel data analysis at the bank level in a study by the Reserve Bank of India (RBI).
In other words, when credit risk increases, commercial banks increase their interest rate spreads to hedge the risk of default, which in turn increases borrowing costs and tightening lending.
A positive shock to the risk premium increases the interest rate spread by 30 basis points and credit and production contracts by 75 and 40 basis points, respectively. This emerges from the study “Risk Premium Shocks and Business Cycle Results in India”.
“It leads to a decline in consumption, investment and the price of capital goods while lowering consumer prices. A mix of expansionary fiscal and monetary policies has been shown to be effective in reducing the risk premium contraction in economic activity and stimulating recovery to accelerate.” Said the authors Shesadri Banerjee, Jibin Jose and Radheshyam Verma.
The authors noted that the Indian banking sector has been going through tough times, weighed down by the overhang of stressed assets and the subsequent decline in profitability.
“The stability of the banking sector, as measured by z-scores, is observed to decline as non-performing assets (NPAs) skyrocketed,” they said.
In addition, the macro-financial links – the standard movements between real and financial variables – appeared to have deteriorated over the period of financial stress.
“Given the signs of high NPAs from banks, we understand financial shock as a shock to the interest rate differential resulting from changes in borrowers’ default risk. It is known as the risk premium shock and is the focus of this study, ”said the authors.