An increase in default risk, captured by gross non-performing assets (GNPA) ratio, drives up interest rate spread and reduces real credit growth, according to a bank-level panel data analysis in an Reserve Bank of India (RBI) study.
In other words, if the credit risk increases, commercial banks raise their interest rate spreads to hedge the risk of default which, in turn, raise the cost of borrowing and tighten up lending.
A positive shock to risk premium increases the interest rate spread by 30 basis points and contracts credit and output by 75 and 40 basis points, respectively, according to the study “Risk Premium Shocks and Business Cycle Outcomes in India”.
“It causes a downturn in consumption, investment and price of capital goods, while softens consumer prices...A mix of expansionary fiscal and monetary policy is found to be effective in reducing the risk premium driven contraction in economic activity and expediting the recovery,” said authors Shesadri Banerjee, Jibin Jose and Radheshyam Verma.
The authors observed that the Indian banking sector has been going through troubled times weighed down by the overhang of stressed assets and the subsequent decline in profitability.
“It is observed that stability of the banking sector, measured by Z-score, declined as non-performing assets (NPAs) shot up,” they said.
Furthermore, macro-financial linkages – the standard co-movements between real and financial variables – appeared to have deteriorated during the period of financial stress.
“Given the evidence of high NPAs of banks, we conceive financial shock as a shock to the interest rate spread stemming from the change in the default risk of borrowers. It is termed as the risk premium shock and occupies the central stage in this study,” opined the authors.