Staff Working Paper No. 1,136
By Somnath Chatterjee
The paper studies the effects of the implicit government guarantee on a sample of six major Indian banks and derives estimates of default risk implicitly ‘insured’ by the government. This is obtained by comparing two measures of default risk for a bank. The first measure is estimated from bank equity prices assuming equity holders are not benefitting from a government bail-out. The second derives from bank Credit Default Swap (CDS) spreads. CDS only pays out if a bank defaults on its debt. Default risk derived from CDS should capture the joint risk of the bank becoming distressed and the government not bailing out creditors. It is typically lower than the default risk derived from equity prices. The difference between the two measures is used to quantify the implicit subsidy to Indian banks. While these subsidies have declined from the levels seen during the global financial crisis and the shock from the Covid-19 pandemic, they remain non-trivial.
The implicit subsidy to the Indian banking system