‘Inter-connected banks expose system to contagion risk’

The Indian banking system faces a possible contagion risk in case of trouble at one bank given the inter-connectedness between some lenders, the Reserve Bank said on Monday.

The central bank emphasised that this inter-connectedness and the possible contagion risk is the reason why it is important to not only monitoring the interconnectedness, but also the counter-parties and magnitude of exposure involved in the connection.

"Analysis of the top five connected banks as trigger banks reveals that the banking system could potentially lose close to 50 per cent of its total tier-I capital under the joint solvency-liquidity condition in the event of a particular bank triggering a contagion," the RBI said in its Financial Stability Report.

"This underscores the importance of monitoring not merely the interconnectedness, but also the counter-parties and magnitude of exposure involved in the connection," it said.

A contagion analysis is conducted to estimate potential loss to the banking system triggered by either one or several banks.

"Though such an analysis may appear hypothetical, it is a good indicator about the toxicity of banks," the report said.

The results further provide an additional input in identifying systemically important banks.

Three types of contagion analysis are generally carried out — solvency contagion, liquidity contagion and joint liquidity-solvency contagion. Solvency contagion is typical to distress generated by failure of a bank which is a net borrower in the financial system.

On the other hand, liquidity contagion is generated by a 'net lender' bank. In the actual world, both solvency and liquidity contagion are likely to emanate simultaneously due to obvious dynamics present in a financial system, the report said.

The banking system continues to be reasonably connected with connectivity ratio, which is a simple estimate of interconnectedness, consistently remaining over 20 per cent in the last three years, it said. .

The network structure of the banking system, which is tiered in nature, reveals that the most connected banks have been the same for the past two years.

The bank, which is systemically the most important, continues to be the same. Public sector banks are the biggest net lenders while private banks are the biggest net borrowers in the interbank market.

The report further said a better perspective of the network structure of the country's financial system emerges when an analysis of the interbank market is extended to asset management companies (AMCs) managing mutual funds and insurance companies.

Both mutual funds and insurance companies are the biggest providers of funds in this system, while public sector banks emerge as the largest receiver of funds.

Total funds raised by the banking sector from mutual funds and insurance companies was to the tune of Rs 5.5 trillion, the report said.