Macro Prudential Analysis (MPA) of credit risk, the predominant risk category of Indian Public Sector Banks (PSBs). Assuming bank-specific shocks to be nil at the micro level, the paper employs a recursive Vector Auto-Regression (VAR) methodology to examine the transmission of shocks from major macroeconomic variables on the default rate of banks. The VAR model is applied to monthly data from the period 1994-2003. This is the first attempt in the Indian context that studies the links between asset quality and macroeconomic shocks using the VAR model. There is no evidence of cyclicality and procyclicality at one month lag as revealed by Granger causality tests. However Impulse Response Functions reveal the existence of cyclical and procyclical patterns over two months. Further shocks to exchange rate and monetary policy significantly affect bank asset quality. The implication of this study is that with the forthcoming Fuller Capital Account Convertibility (FCAC), banking sector in India is likely to be under increased stress in view of the exchange rate volatility and consequent rise in interest rates. In this scenario monetary policy emerges as an important precondition for banking stability. It may be suggested that the authorities need to take a balanced overview of financial stability in aggregate rather than focusing on price stability alone.

Ever since the Narasimham committee recommendations on banking reforms were implemented, a new era has been ushered in the Indian banking sector. Our banks are emerging as stronger entities in the contemporary deregulated and liberalized environment. They have managed to reduce their bad loans and are focusing on better lending practices. In spite of this improving landscape, it is of great importance to know how the effects of the changing macroeconomic scenario and policy shifts work upon the financial health of banks. In the globalized era, empirical literature has underlined the role of macroeconomic variables, including monetary and financial variables, on the health of the banking sector in several developing and developed countries. It thus appears important to undertake a similar study in this regard in the Indian context as well.

This study employs a recursive Vector Auto-Regression (VAR) approach and makes an attempt to examine the dynamic interactions between the default rate of Indian Public Sector Banks (PSBs) and a few selected macroeconomic variables in the post-liberalization period. The contribution of this paper lies in employing a multivariate VAR model for the analysis of the impact of business cycles on the asset quality of banks as well as the feedback effect to the real economy. We also try to examine how the new monetary regime impacts the loan quality of banks.