Indian corporate firms are more prone to the systematic downside risk. The firms? profitability as well as solvency status change with the business cycle. During an expansionary phase of economic cycle, when demand is high and business is strong, firms have a higher probability of profit and therefore fewer defaults will happen. Whereas during a recession, keeping a business profitable is more challenging and it is more likely that a firm would default. Default probabilities and hence rating status of bigger companies depend strongly on the stage in the business cycle. Rating cyclicality reflects the impact of macro-economic factors on the credit quality of issuers. Because of this, banks? loan business tends to follow the same cyclical pattern as that of the real economy.
During periods of economic calm, concentrations in an institution?s portfolio are unlikely to have any noticeable adverse effects on performance or credit quality. However, the real threat arises in an adverse economic scenario. To investigate the pro-cyclical behaviour of corporates, we have studied their monthly as well as annual rating movements of various debt instruments. We have observed that corporate rating transitions tend to exhibit a higher frequency of downgrades during a recession and a higher occurrence of upgrades during booms. There is also a significant difference in corporate default rates for the good years as compared to the bad years.
It is quite evident from the accompanying chart that there is a link between business cycle and corporate risk profile in India. A contraction in IIP growth rate increases the default rates. A time series co-movement test (statistically termed as ?co-integration?) between the three non stationary variables: default rate (default), IIP growth (IIPGR) and non-food credit growth (credit growth) detects a significant, long-term relationship amongst them. The equilibrium relationship can be expressed by the equation: default = -4.845 + 0.567 ? IIPGR- 0.194 ? credit growth. However, this correlation does not necessarily imply meaningful causation between these three macro-variables. A Granger Causality test (a statistical hypothesis test to check whether one time series variable is useful in forecasting another) reveals corporate default rates causes IIP growth rate and IIP growth rate causes the credit growth rate. A two-period time lag has been chosen to conduct the test. This means, an increase of default of corporate debt instruments crowds out the industry growth rate and a fall in growth rate further slows down the credit supply.
In addition, more ratings are downgraded than upgraded during an economic downturn. It can be seen in the accompanying chart that whenever GDP growth rate was high, downgrade-to-upgrade ratio was low and when GDP growth rate was down, the downgrade-upgrade ratio also picked up. One can also notice that the rating suspension rate picks up when growth decelerates. This provides early warning signal about increase in corporate default risk in India. Increase in rating suspension rate indicates deteriorating financial health of the corporate organisations. As a result, the risk-weighted assets of banks go up, which puts a downward pressure on their capital adequacy ratio (CAR). This ultimately slows down the credit growth.
When the market becomes tight, default rates pick up, interest rate goes up, credit growth slows down and IIP growth decelerates. Hence, loans typically show strong growth in an economic upturn and slow growth or even contraction in an economic downturn and so does the bank?s capital structure. Since bank loans have major long-term impact on the GDP, a fall in credit supply will further push the economy into recession as the firms will not get the bank loan when they need it and the vicious circle will continue.
To counter the pro-cyclical effect, it is recommended that banks have a strong stress-testing framework for scenario analysis. This will enable them to be better prepared for this unexpected increase in credit risk in their corporate loan portfolio. The scenario analysis shown in this piece of research should guide the senior management of banks to adopt an effective capital plan to safeguard themselves from adverse economic conditions. Banks also need ?early warning signal? financial scoring models to predict potential distress .
A concentrated loan portfolio in a bank under a stress situation would result in large losses relative to a more diversified portfolio. The regulatory authorities are also involved in monitoring the systemic risk and set various macro-prudential policies, e.g., in the form of counter-cyclical buffer under Basel III rules, dynamic provisioning norms, monetary measures, setting stress testing guidelines, prudential limits etc.) to dampen these pro-cyclical behaviors and ensure economic stability.
Arindam Bandyopadhyay
The author is associate professor (finance), National Institute of Bank Management Pune. Views are personal