The Indian banking system faces a possible contagion risk in case of trouble at one bank given the inter-connectedness between some lenders, the Reserve Bank said today.
The central bank emphasised that this inter-connectedness and the possible contagion risk is the reason why it is important to not only monitoring the interconnectedness, but also the counter-parties and magnitude of exposure involved in the connection.
"Analysis of the top five connected banks as trigger banks reveals that the banking system could potentially lose close to 50 per cent of its total tier-I capital under the joint solvency-liquidity condition in the event of a particular bank triggering a contagion," the RBI said in its Financial Stability Report.
"This underscores the importance of monitoring not merely the interconnectedness, but also the counter-parties and
magnitude of exposure involved in the connection," it said.
A contagion analysis is conducted to estimate potential loss to the banking system triggered by either one or several banks.
"Though such an analysis may appear hypothetical, it is a good indicator about the toxicity of banks," the report said.
The results further provide an additional input in identifying systemically important banks.
Three types of contagion analysis are generally carried out -- solvency contagion, liquidity contagion and joint liquidity-solvency contagion.
Solvency contagion is typical to distress generated by failure of a bank which is a net borrower in the financial system.
On the other hand, liquidity contagion is generated by a 'net lender' bank.
In the actual world, both solvency and liquidity contagion are likely to emanate simultaneously due to obvious dynamics present in a financial system, the report said.
The banking system continues to be reasonably connected with connectivity ratio, which is a simple estimate of interconnectedness, consistently remaining over 20 per cent in the last three years, it said.
