Market discipline and the risk-taking behaviour of banks in India

Abstract

After the financial crisis, the Indian banking system has accumulated a mountain of bad loans which has crippled the banking sector and halted the credit flow to the industry. Several immediate causes for the bad loan crisis have been pointed out. However, poor market discipline, the ultimate root cause of the bad loan crisis, has not been paid adequate attention. This study seeks to investigate how effectively the market disciplinary forces, captured through information disclosure, interbank deposits, concentration and owner- ship structure, incentivise the Indian banks to adopt prudential risk manage- ment by enhancing their risk-weighted capital ratio. The findings of the study show that information disclosure and interbank deposits do not induce prudential risk behaviour among banks in India. However, with increasing concentration in the banking sector, a higher level of information disclosure effectively induces banks to maintain higher capital ratios, but inter-bank deposits do not have any significant effect on bank capital. We also observe that government banks maintain lower capital ratios as compared to private banks indicating government banks' higher expectation of government bailout.