Indicators of Banking Fragility in India: An Empirical Test

The study presents an early warning system for predicting banking fragility in India. Using the index method, distress episodes in the banking system are identified during 1994–2007. On the basis of standard tools of probit regression models, the results indicate growing interlinkages of economic liberalization with the Indian banking sector. Slowdown in real output, increase in headline inflation rate, increase in spread between the central bank policy rate and short-term risk-free rate, increase in proportion of broad money supply to foreign exchange reserves, REER overvaluation from trend and decrease in proportion of trade balance to GDP enhance the probability of banking fragility in India. The behaviour of the identified crucial indicators, cross-checked by the signal extraction approach, reveals adequate signalling power due to their low Noise-to-Signal Ratio. The estimated ‘lead time’ of the indicator variables in signalling banking distress also offers a modest time period to the government to initiate pre-emptive policy action to strengthen the banks.