Government Guarantees and Bank Vulnerability During a Crisis: Evidence from an Emerging Market

Abstract

We analyze the performance of Indian banks during 2007–09 relative to their vulnerability to a crisis measured using pre-crisis data, in order to study the impact of government guarantees on bank performance during a crisis. Using bank branch-level regulatory data, we exploit geographic variation in the exposure to state-owned banks to show that vulnerable private sector bank branches in districts with greater exposure to state-owned banks experienced deposit withdrawals and shortening of deposit maturity. In contrast, nearby vulnerable state-owned bank branches grew their deposit base and increased loan advances but with poorer ex-post performance of loans. Our evidence suggests that access to stronger government guarantees during aggregate crises allows even vulnerable state-owned banks to access and extend credit cheaply despite their under-performance, and this renders private sector banks especially vulnerable to crises.