Examining the interconnectedness and early warning signals of systemic risks of shadow banks: an application to the Indian shadow bank crisis

Abstract

PurposeThe paper models the financial interconnectedness and systemic risk of shadow banks using Granger-causal network-based measures and takes the Indian shadow bank crisis of 2018–2019 as a systemic event.Design/methodology/approachThe paper employs pairwise linear Granger-causality tests adjusted for heteroskedasticity and return autocorrelation on a rolling window of weekly returns data of 52 financial institutions from 2016 to 2019 to construct network-based measures and calculate network centrality. The Granger-causal network-based measure ranking of financial institutions in the pre-crisis period (explanatory variable) is rank-regressed with the ranking of financial institutions based on maximum percentage loss suffered by them during the crises period (dependent variable).FindingsThe empirical result demonstrated that the shadow bank complex network during the crisis is denser, more interconnected and more correlated than the tranquil period. The closeness, eigenvector, and PageRank centrality established the systemic risk transmitter and receiver roles of institutions. The financial institutions that are more central and hold prestigious positions due to their incoming links suffered maximum loss. The shadow bank network also showed small-world phenomena similar to social networks. Granger-causal network-based measures have out-of-sample predictive properties and can predict the systemic risk of financial institutions.Research limitations/implicationsThe study considers only the publicly listed financial institutions. Also, the proposed measures are susceptible to the size of the rolling window, frequency of return and significance level of Granger-causality tests.Practical implicationsSupervisors and financial regulators can use the proposed measures to monitor the development of systemic risk and swiftly identify and isolate contagious financial institutions in the event of a crisis. Also, it is helpful to policymakers and researchers of an emerging economy where bilateral exposures' data between financial institutions are often not present in the public domain, plus there is a gap or delay in financial reporting.Originality/valueThe paper is one of the first to study systemic risk of shadow banks using a financial network comprising of commercial banks and mutual funds. It is also the first one to study systemic risk of Indian shadow banks.

Are shadow banks a threat to the financial stability of EMEs?

“…Thus, the growth of finance companies increases the financial vulnerability of EMEs. The findings are aligned with Chaturvedi and Singh (2022), who report NBFCs to be interconnected and posing a threat of systemic risk (in the Indian context). Bank-specific variables such as cost-to-income ratio, regulatory ratio and NIM indicate similar relationships as in prior literature.…”

“…The findings indicate that the growth of shadow banks causes financial vulnerability, corroborating the findings in the extant literature (Bengtsson, 2013; Chaturvedi & Singh, 2022). Furthermore, the growth of finance companies is also found to be causing financial instability in EMEs.…”

“…(2015) who discussed that higher shadow banking creates financial fragility in the financial system. NBFIs are pro-cyclical in nature, that is, they assume innumerable risks in the boom periods and suffer in the bust periods (Chaturvedi & Singh, 2022). Furthermore, the study finds a positive relationship between the growth of EF2 assets and overall instability.…”

“…They also constructed a health score to predict the financial fragility of these NBFCs. Chaturvedi and Singh (2022) studied the interconnectedness and systemic risks of the NBFI sector in India. They deployed Granger causality and based their research on 2018-19 crisis period of Indian NBFCs (failure of a large NBFC led to crisis in Indian financial markets).…”

“…Post the GFC of 2008, various studies highlighted the detrimental effect of shadow banking on the financial stability of economies due to their asset–liability mismatches and lack of explicit government guarantees (Adrian & Ashcraft, 2012; Bengtsson, 2013). Empirical evidence shows them to be dependent on short-term funding and highly interconnected with OFIs (Anshuman & Sharma, 2020; Chaturvedi & Singh, 2022; Verma & Chakarwarty, 2023).…”