The paper analyzes the insolvency risk of commercial banks in India for the period 1998-2007. This has primarily been motivated by the changes in the structure and conduct consequent upon the banking sector reforms which have gradually brought the much-desired dynamic and competitive forces into the system that enabled banks to perform better by way of flexibility in their operations and diversification into organic and inorganic lines of business, notwithstanding the market-induced vulnerabilities. Though reforms have facilitated reduction in cost of deposits and cost of funds across all bank groups and improvement in the return on assets, facilitated by higher spread and lower burden, nonetheless, there is persistence of significant disparity among banks in their conduct, performance, cost minimization and on the risk management front. Using ‘Z-score’ measure of insolvency risk and panel data econometrics, it is found that the Indian private banks are most risky, whereas the foreign banks are found to be least risky for their fat capital cushion. The Public Sector Banks (PSBs) are in the intermediate category in terms of their risk levels. Further, higher competition tends to induce risk unless there are efficiency improvements across the banks. Diversification is also found to have a risk-mitigating effect; however, diversification per se is not sufficient condition for lowering the risk; rather, selective diversification coupled with buffer capital could yield the sufficient condition for banks’ safety. While the banks have adapted themselves to the changing environment, the fast evolving financial landscape continues to pose several challenges. Therefore, banking regulation assumes increasing significance in these changing environments for adequate assessment of risk and to discourage risky behavior.

The Indian financial system is characterized by the dominance of banking institutions which account for three-fourths of the financial sector assets. The state control over commercial banks helped in resource mobilization, geographical diversification and social and development banking, but the strategy did not succeed on the competitiveness, efficiency, profitability, and technological fronts. To mitigate these ill effects, a set of banking sector reforms was introduced, following the recommendations of the Narasimham Committee (GOI, 1992; and GOI, 1998), so as to ensure safety and soundness of the banking system, and also a level playing field for all banks.

There has been a change in the structure, conduct and performance of the commercial banking industry in the post-reform period. The share of Public Sector Banks (PSBs) in the commercial banking sector declined from 89% in 1992 to 70% in 2007, whereas the share of private sector banks increased from 4% to 22% in the same period. Foreign banks group has recorded a marginal improvement. The ratio of Off-Balance Sheet (OBS) to balance sheet activities has also shown an increase (see Table 1A of Appendix). As a result, the noninterest income has increased for many banks. The performance indicators show that though there is an improvement on the non-performing asset and capital adequacy front, there is a significant disparity among banks in the spread, burden, cost of fund and the return on assets. For example, there are loss-making banks in each year under consideration, particularly in the private sector and foreign category (see Table 2A of Appendix). This indicates that there is considerable disparity among banks in cost minimization and risk management. The disparity among banks is also noticeable on the technological upgradation front (e.g., number of ATMs per branch); as a result the private sector and foreign banks are able to do more business per branch. These changes in the structure and conduct of operations are believed to have implications for banks’ performance and risk. Therefore, the paper analyzes the insolvency risk of commercial banks and of different bank groups in an environment seemingly characterized by increasing competition and activity diversification that has been made conducive by the reform and regulations. It also tries to fill a visible research gap by addressing the trends and determinants of the overall bank risk. Earlier studies (Das, 2002) were not comprehensive in terms of the quantification of risk and coverage. The importance of studying the risk behavior is immense in view of the nodal characteristics of commercial banks in maintaining financial stability and economic growth.

Applied Finance Journal, Winter Blues, Stock Market Returns, Tunisian Stock Exchange, Trading Strategies, Stock Market Anomalies, Tunisian Stock Market, OLS Regression Method, Clinical Research, Risk Aversion.