Can Financial Markets Predict Banking Distress? Evidence from India

Abstract

In this paper, we test whether the efficient market hypothesis works in the context of Indian banking sector. In particular, using a panel dataset of 39 publicly listed banks in India for 2009–2017, we test whether equity markets provide any lead information about stress in the banking system before quarterly data becomes available to the supervisors. We find that markets are able to price-in the banking stress concurrently but not much in advance. As the supervisory data are available with a lag, there is some merit in incorporating market-based information to track banking distress. Use of a machine learning technique to reaffirm the results is a novelty of this paper. Interestingly, our findings suggest that markets are relatively less efficient in the case of public sector banks vis-à-vis private sector banks.

Keywords: banking sector, banking distress, equity markets, financial stability

JEL Classification: C14, C33, C51, G21, G14