Banking Catch-22: Trading off Mark-To-Market and Default Risk in the Presence of Guaranteed Deposits
With Karthik Narayan and Akshat V. Singh
Manuscript available on request.
We provide evidence that the deposit franchise of privately owned banks is driven by their deposit market concentration while state owned banks derive their franchise value from government guarantees. Using the boom period of the 2000s in India as a laboratory, when monetary policy tightened precipitously, we document that banks with stronger deposit franchises significantly increased exposure to the infrastructure sector, at the expense of investing in marked-to-market
government securities. Subsequently, these banks have higher non-performing loans. This highlights an important trade-off between mark-to-market and default risk for banks, particularly in economies with incomplete asset markets and significant state guarantees for banking assets.
Heterogeneity by Investment Fluctuation Reserve
Political Economy of Government Borrowing and Financial
Crowding Out: Evidence from India
With Viral V. Acharya, Rahul S. Chauhan, and Kavya Ravindranath
Manuscript available on request.
What are the implications for private firms of government borrowing in markets with heavy state presence in bank ownership? In this paper, we document crowding-out effects on top-rated private firms due to portfolio substitution away from safe-asset substitutes by government-owned banks, occurring due to excess state government borrowing around elections. Using regulatory primary auctions data of Indian state government securities, we show that in the year before state elections, states ruled by the same party as the central government (aligned states) increase issuance of SDLs by 28% and at 40 basis points lower yields. Importantly, state-owned banks purchase this issuance at a significant discount, engaging in a safe-asset substitution by replacing top-rated firm debt with state government securities. We show that this crowds out corporate borrowing of top-rated firms headquartered in aligned states, with effects driven by lending contraction by state-owned banks. Top-rated firms (i) reduce borrowing by 14% and see a 5 to 15 basis point rise in their average interest rates, (ii) contract their investment-to-asset ratio by 19%, (iii) reduce sales by 8%, and (iv) reduce their wage bill by 4.3%. Aligned states also increase revenue expenditure’s share in total outlay by 3.6 percentage points, which is correlated with 0.17 percentage points higher chances of getting re-elected.
SDL Issuance
Aligned States
Non-Aligned States