Measurement of Bank Risk, Systematic

Risk and its Implications in the Context of

Indian Banking Sector

A dissertation Supervised by: Dr. Duke Ghosh

Submitted by:

Ninad Kartikbhai Shah (40A)

M.A Economics (2021-23)

Indian Institute of Foreign Trade

Table of Contents

Abstract ........................................................................................................................... I
1. Introduction ................................................................................................................ 1
1.1 Research Objectives ............................................................................................. 2

2. Literature Review....................................................................................................... 3
3. Data & Research Methodology .................................................................................. 5
3.1 Z-score as a measure of Bank risk ....................................................................... 5

3.2 Different approaches to Z-score measures ........................................................... 7

3.3 Aggregate Z-score ................................................................................................ 8

3.4 Minus one bank risk measure ............................................................................... 9

3.5 Relationship between Demand Deposits and Z-score: ....................................... 11

4. Results ...................................................................................................................... 12
4.1 Individual bank Z-scores and their interpretations ............................................. 12

4.2 Aggregate Z-score: Results ................................................................................ 16

4.2.1 Sector-wise comparison ............................................................................... 18

4.3 Minus one bank aggregate Z-score: Results ...................................................... 20

4.4 Relationship between Demand deposits and Z-score ......................................... 24

5. Conclusion ............................................................................................................... 26
References .................................................................................................................... 28
Appendix ...................................................................................................................... 29
A1: Individual Z-scores for Public Sector Banks..................................................... 29

A2: Individual Z-scores for private sector banks ..................................................... 31

A3: Unit root test on dependent variable ................................................................. 32

Table 1: Z-scores for Bank of India ......................................................................................... 12
Table 2: Correlation matrix ...................................................................................................... 13
Table 3: RoA, CRAR and Z-scores for State Bank of Mysore ................................................ 14
Table 4: Z-scores for State Bank of India ................................................................................ 15
Table 5: Descriptive statistics pf Aggregate Z-score for public sector banks .......................... 18
Table 6: Descriptive statistics of Aggregate Z-score for private sector banks ......................... 19
Table 7: Descriptive statistics of RoA ..................................................................................... 20
Table 8: Descriptive statistics of aggregate and minus one bank aggregate Z-scores for public
sector banks .............................................................................................................................. 21
Table 9: Descriptive statistics of aggregate and minus one bank aggregate Z-scores for private
sector banks .............................................................................................................................. 22
Table 10- Descriptive Statistics of Z-score for private sector banks ......................................... 30
Table 11- Descriptive Statistics of Z-score for private sector banks ........................................ 32

Figure 1: Z-score measures for State Bank of India ................................................................ 15

Figure 2: Descriptive statistics of Aggregate Z-score .............................................................. 16
Figure 3: Aggregate Z3 & Z3 measures ................................................................................... 17
Figure 4: Aggregate Returns to Assets & Capital to Assets ratio ............................................ 17
Figure 5: Sector-wise Aggregate Z3 scores ............................................................................. 19
Abstract

This paper applies different methodologies of calculating Z-score to assess individual

bank’s risk of insolvency and systematic risk in the Indian banking sector. This paper solely
focuses on Indian banking sector. Using aggregate Z-score, this study tries to compare between
public sector banks and private sector banks and their contribution towards the systematic risk
in the banking sector as a whole. Further it uses minus one bank aggregate Z-score to quantify
individual bank’s contribution towards the systematic risk. At last, it tries to predict financial
distress in advance by looking at how system-wide changes in Z-score this period leads to
system-wide changes in demand deposits next period (system-wide decrease in demand
deposits is an indicator of financial distress).

I
1. Introduction

For any firm or corporation, its ability to sustain and to be solvent in adverse economic
conditions is very important. Many corporations go bankrupt and out of business when they
face these extreme economic conditions and they have their own consequences on stakeholders
of those firms. But Banks are little different kind of corporations which are considered “Too
big to Fail”. Those businesses or sectors which are deeply ingrained in the economy or
financial system and whose failure can have large spill-over effects on every other productive
sectors of economy and can be disastrous to the economy are called as “Too big to Fail”,
Government cannot afford to let these businesses or sector fail.

Since banking sector is the most important sector for the economy as a whole, making
sure that banks are efficiently regulated and minimizing their risks of going bankrupt is of top
priority for policymakers. Post 2008 Global Financial Crisis importance of proper attention
towards banks’ insolvency and liquidity risk has increased.

During financial distress, it often happens that poor performance of any large bank can
then have greater impact on other banks and financial system as a whole due to spill-over
effects. And systematic risk in financial system may be caused by these spill-over effects.
Hence in order to regulate banks’ risk, it is important to measure the systematic risk in a proper
way.

In India all banks are regulated under the “Banking Regulation Act (1949)”. Indian
banking sector currently is following BASEL II guidelines. RBI began implementing BASEL
I in 1992, BASEL II in 2009 and it has already issued guidelines This study aims to focus at
measurement of bank risk and systematic risk in the Indian banking sector. For measurement
of bank risk this study intends to use Z-score as a measure. In recent past Indian banking sector
has seen one of its co-operative bank going through a crisis which has increased its bank risk
and overall systematic risk too. This study tries an attempt to measure bank risk and systematic
risk using Z-score. Measuring bank risk and systematic risk is important because it is a direct
proxy for insolvency of bank, i.e. bank with high risk is more vulnerable to insolvency. This
work will provide a relative comparison among banks taken into study and risks associated to
them. Also this work, once done successfully will enable us to see the contribution of each
bank to the overall measure of systematic risk of sector and which banks are systematically

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important in the sector meaning that if these banks go bankrupt that will be disastrous for the
financial system and economy as a whole.

For purpose of this study we will focus ourselves to Z-score for measuring bank risk
and systematic risk in the sector. But there are other commonly used risk measures like Value
at Risk (VaR) and Expected Shortfall (ES). BASEL II accord recommends VaR as standard
measure of bank risk for risk management in the banking sector while BASEL III accord
recommends ES as a standard measure of risk.

1.1 Research Objectives

Objectives of this paper are as follow:

1) Proper measurement of systematic risk in Indian banking sector

2) Measurement of individual bank risk and their contribution to overall systematic risk
3) Identify systematically significant banks in the banking sector
4) Empirically estimate relationship between demand deposits and Z-score in order to
predict financial distress in advance

Note: Bank risk in this paper is defined as bank’s risk of insolvency; whenever word
bank risk is used in this paper, it should be interpreted as bank’s risk of insolvency.

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2. Literature Review

There have been many influential work done in the field of measurement of risk using
Z-score. (Altman, 1968) used Z-score in order to study prediction of corporate bankruptcy. In
this paper, to predict corporate bankruptcy in manufacturing corporations, how different
financial and economic ratios can be used employing a multiple discriminant statistical
methodology. To compute Z-score, five variables were selected in prediction of corporate
bankruptcy which were: working capital to total assets, retained earnings to total assets, sales
to total assets, market value of equity to book value of date and earnings before interest and
taxes to total assets. Z-score as defined by Altman is a linear combination of these five financial
ratios. Conclusion of his study was that his bankruptcy prediction model turned out to be
accurate predictor of failure up to two years prior to the bankruptcy but this accuracy
diminishes as we increase the years prior to bankruptcy. Altman’s Z-score is generally used to
predict insolvency of corporate firms. But as we have already discussed in the introduction that
banks are a little different kind of corporations as compared to manufacturing corporates; banks
are highly leveraged so Altman’s Z-score may not be appropriate to use in analysis of bank risk
and systematic risk in the banking sector.

(Yeyati & Micco, 2007) in their working paper used Z-score to assess risk in the Latin
American Banking sectors. In this study they used Z-score to again measure and assess risk of
insolvency of banks in Latin America. During that time Latin American banking sector was
witnessing sudden increase in foreign bank participation. These foreign banks acquired poor
performing domestic banks and hence competition in banking sector was expected to decrease.
Their study sought to find out the effect of this internationalisation on stability of banking
sector in Latin America. In conclusion they found out that due to mergers of international
banks, increased concentration (decreased competition) had no influence on bank insolvency
risk. They defined their Z-score based on Chebishev inequality, which was a proxy for the
probability that bank will go insolvent. In their study for bank stability, dependent variable was
bank risk as measured by Z-score and independent variables were Economic growth, Exchange
rate volatility, Competition and Bank concentration. As expected they found that economic
growth and exchange rate volatility has positive and negative sign for their coefficients
respectively and competition increases bank risk while they found coefficient of bank
concentration to be statistically insignificant implying thereby that internationalisation of

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banking had no effect on insolvency of banks. They concluded this study by stating that
increased internationalisation had increased bank concentration and hence weakened
competition among banks, fall in competition implied decreased bank risks, so ultimately
foreign banks’ entry into the Latin American banking sector led to reduced bank risks, and
surprisingly this was not because of the entry of safer foreign banks but foreign banks in this
sector were more risker than the national banks because of their higher leverage ratios and more
volatile returns.

(Li, Tripe, & Malone, Measuring bank risk: An exploration of z-score, 2017) in their
paper explored different methodologies of computing Z-scores to assess bank risk. Their essay
focused on study of bank risk measures using accounting data with main focus on Z-score.
They took New Zealand banks for empirically measure bank risks and systematic risk in that
sector. Their study was focused around the time of Global financial crisis. Just before the
financial crisis, they saw upward trend in Z-score meaning greater banking stability but Z-score
declined drastically during 2008-10 when financial crisis happened.

There are different methodologies of calculating Z-scores; they all have their merits and
demerits. But till date there is no consensus among researchers in this particular field as to
which methodology is best in assessment of bank’s risk of insolvency. That is why (Lepetit &
Strobel, 2014) tried to summarize different approaches to estimate Z-scores which were
originally used by authors like (Boyd, Nicolò, & Jalal, 2006), (Yeyati & Micco, 2007) and
(Hesse H, 2007). (Lepetit & Strobel, 2014) then used data on commercial, cooperative and
savings banks to estimate Z-scores using different approaches for G20 countries. My study
takes inspiration from this paper and uses these different approaches of estimating Z-scores for
public and private sector banks to assess systematic risk in Indian banking sector. Their paper
concluded that to calculate time varying Z-score, it should be estimated using current period’s
capital-asset ratio, mean and standard deviation of returns on asset calculated over whole
sample period in consideration. Their proposed approach is fairly simple to estimate and quite
good predictor of bank risk.

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3. Data & Research Methodology

This project is divided into four segments and for each segment required data have been
collected separately. Presently Indian banking sector consists of 12 public sector banks, 21
private sector banks, 43 regional rural banks(RRBs), other small finance banks, payment banks,
and various co-operative banks. Data for banks other than public sector banks and private sector
banks are hardly available. Hence to represent Indian banking sector as a whole, this paper
includes public and private sector banks. Indian banking sector used to consist of more public
sector banks but their number has reduced to 12 after many mergers during last decade. In this
paper, I have also included these public sector banks which have been acquired by other public
sector banks.

In the first segment, I have computed individual Z-scores for a sample of 27 public
sector banks and 21 private sector banks using different approaches. For this purpose, data of
banks’ returns on assets and capital adequacy ratio have been collected from RBI’s data
warehouse for the period between 2005-22. In the second segment, I have computed aggregate
Z-score for banking sector as a whole and sector-wise aggregate Z-scores. For that data on net
profits, total assets and total equity have been collected for the same set of banks using
Bloomberg database and for some cases using annual reports of some banks for the period
between 2005-22. In the third section, to compute minus one bank aggregate Z-scores, data on
net profits, total assets and total equity have been collected for sample of 25 banks currently
existing in the banking sector, out of which 10 of those are public sector banks and rest are
private sector banks. In the fourth and last segment of this paper, I have collected data for
demand deposits held by this same set of banks for the same period of 2005-2022 from
Bloomberg data base.

3.1 Z-score as a measure of Bank risk

Traditionally in literature, Z-score is widely used as a proxy measure of bank risk. Bank
risk is defined to be the probability of event in which bank becomes insolvent. Bank can

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become insolvent when its 𝐶𝐴𝑟 + 𝑅𝑜𝐴 ≤ 0, where 𝐶𝐴𝑟 is Capital to Asset ratio and 𝑅𝑜𝐴 is
Return on Assets for bank. Z-score has been widely used lately by many researchers because
of its simplicity in calculation. It does not need any market related data like Earning per Share
or market values of share but it only requires balance sheet data for computation. Since by law
it is mandatory for all banks around the world to maintain statutory financial statements like
balance sheet, profit & loss statement and cash flow statement etc, necessary data required to
compute Z-score is easily available for most cases. Z-score is calculated as follow:

(𝐶𝐴𝑟 + 𝑅𝑜𝐴)
𝑍=
𝜎(𝑅𝑜𝐴)

Where 𝐶𝐴𝑟 is Capital-Asset ratio, 𝑅𝑜𝐴 is Returns to Asset and 𝜎(𝑅𝑜𝐴) is standard
deviation of Returns to Asset. Higher returns to asset and higher capital-asset ratio both are
desired for a bank while higher volatility depicted by higher standard deviation of returns on
asset is undesirable for a bank. Higher volatility of a bank’s returns have a negative impact on
Z-score. So higher Z-score is more desirable and it shows that bank risk is comparatively low.
Bank having a high Z-score is considered less risky as compared to bank having low Z-score.
It shows the number of standard deviations of a bank’s returns on asset has to drop before the
bank becomes insolvent.

𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡

By definition, 𝐶𝐴𝑟 = and 𝑅𝑜𝐴 = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠. For computation of aggregate
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

Z-score I have used 𝐶𝐴𝑟 and 𝑅𝑜𝐴 as defined here. But for computation of individual Z-scores,
capital adequacy ratio has been proxied in place of 𝐶𝐴𝑟.

𝑇𝑖𝑒𝑟 1 𝑐𝑎𝑝𝑖𝑡𝑎𝑙+𝑇𝑖𝑒𝑟 2 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐴𝑑𝑒𝑞𝑢𝑎𝑐𝑦 𝑅𝑎𝑡𝑖𝑜(𝐶𝑅𝐴𝑅) = .
𝑇𝑜𝑡𝑎𝑙 𝑅𝑖𝑠𝑘 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠

Capital adequacy ratio is also known as Capital to Risk weighted Assets Ratio (CRAR).

Banking business is different from the traditional businesses in a sense that balance
sheet of a bank is highly leveraged; with very low percentage of equity capital, debt is major
part of its liabilities. Since bankers’ have limited liability they tend to have an incentive to
maximize the bank’s leverage. Because banks’ liabilities consist of huge debt: Majority of
global banking groups based in advance developed countries operated from early 2000s to 2010
with less than 3% equity capital as percentage of their total assets.(Principles of Banking
Regulation, Kern Alexander) Implying that even a 3 % losses on assets would deplete entire
equity capital of banks and thus insolvent. That is why capital regulations are very important
and maintaining Capital Adequacy is mandatory. BASEL III norms suggest that banks must

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maintain minimum capital adequacy ratio of 8% while RBI guidelines asks banks to maintain
minimum capital adequacy ratio of 9%.

3.2 Different approaches to Z-score measures

Approach Z1: (Boyd, Nicolò, & Jalal, 2006) (section III.A) use following equation to estimate
time varying Z-score

𝜇𝐶𝑅𝐴𝑅,𝑡 (𝑛) + 𝜇𝑅𝑜𝐴,𝑡 (𝑛)

𝑍1 =
𝜎𝑅𝑜𝐴,𝑡 (𝑛)

Where 𝜇𝐶𝑅𝐴𝑅,𝑡 (𝑛) is estimated moving mean of CRAR, 𝜇𝑅𝑜𝐴,𝑡 (𝑛) is estimated moving mean
of RoA and 𝜎𝑅𝑜𝐴,𝑡 (𝑛) is estimated standard deviation of RoA, all three calculated for each
period 𝑡 ∈ {1,2, … , 𝑇} and for window length of n=3 years.

Approach Z2: (Yeyati & Micco, 2007) use following equation to estimate time varying Z-score

𝐶𝑅𝐴𝑅𝑡 + 𝜇𝑅𝑜𝐴,𝑡 (𝑛)

𝑍2 =
𝜎𝑅𝑜𝐴,𝑡 (𝑛)

Where 𝐶𝑅𝐴𝑅𝑡 is current period’s capital adequacy ratio, 𝜇𝑅𝑜𝐴,𝑡 (𝑛) is estimated moving mean
of RoA and 𝜎𝑅𝑜𝐴,𝑡 (𝑛) is estimated standard deviation of RoA, calculated for each period 𝑡 ∈
{1,2, … , 𝑇} and for window length of n=3 years.

Approach Z3: (Hesse H, 2007) use following equation to estimate time varying Z-score

𝐶𝑅𝐴𝑅𝑡 + 𝑅𝑜𝐴𝑡
𝑍3 =
𝜎𝑅𝑜𝐴

Where 𝐶𝑅𝐴𝑅𝑡 and 𝑅𝑜𝐴𝑡 are current period’s capital adequacy ratio and returns to asset ratio
while 𝜎𝑅𝑜𝐴 is standard deviation of RoA calculated over full sample period {1,2,…,T}.

Approach Z4: (Boyd, Nicolò, & Jalal, 2006) (section III.B) use following equation to estimate
time varying Z-score

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 𝐶𝑅𝐴𝑅𝑡 + 𝑅𝑜𝐴𝑡
𝑍4 =
𝜎𝑅𝑜𝐴,𝑖𝑛𝑠𝑡

Where 𝐶𝐴𝑟𝑡 and 𝑅𝑜𝐴𝑡 are current period’s capital-asset ratio and returns to asset ratio while
𝜎𝑅𝑜𝐴,𝑖𝑛𝑠𝑡 = |𝑅𝑜𝐴𝑡 − 𝜇𝑅𝑜𝐴 |, (𝜇𝑅𝑜𝐴 = 𝑇 −1 ∑𝑇𝑡=1 𝑅𝑜𝐴𝑡 ) is called as instantaneous standard
deviation estimates for returns on asset because it shows how instantaneous RoA is dispersed
from its mean value.

Approach Z5:

𝐶𝑅𝐴𝑅𝑡 + 𝜇𝑅𝑜𝐴
𝑍5 =
𝜎𝑅𝑜𝐴

Where 𝐶𝑅𝐴𝑅𝑡 is current period’s capital adequacy ratio while 𝜇𝑅𝑜𝐴 and 𝜎𝑅𝑜𝐴 is mean and
standard deviation of RoA calculated over full sample period {1,2,…,T}.

One of the objectives is to see how these approaches are different from each other and
which approach is best in measuring banks’ risk.

3.3 Aggregate Z-score

To compute aggregate Z-score which would show aggregate bank risk in the banking
sector, i.e. systematic risk in the sector, it might seem intuitive that aggregate Z-score should
equal weighted average of banks’ individual Z-scores. But this is not true since there exist
imperfect correlation between banks’ returns on assets. The aggregate z-score is a weighted
average of banks’ individual z-scores if and only if banks’ returns on assets are perfectly
correlated (IJtsma, Spierdijk, & Shaffer, 2017). Then aggregate Z-score can be calculated by
aggregating data for all banks in the sector. For this purpose, in this paper I have aggregated
data for total of 37 banks out of which 23 are public sector banks and 18 are private sector
banks. Required data have been collected for time period between 2005-2022. It should be
noted that in this sample there were some public sector banks which were merged with other
public sector banks in 2017 and thus data for those merged banks are available till 2017.

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 𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 (𝐶𝐴𝑟) + 𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒(𝑅𝑜𝐴)
𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝑍 − 𝑠𝑐𝑜𝑟𝑒 =
𝜎(𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒(𝑅𝑜𝐴))

∑𝑘
𝑖=1 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡𝑠𝑖,𝑡
Where 𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒(𝑅𝑜𝐴)𝑡 = ∑𝑘
and 𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒(𝐶𝐴𝑟)𝑡 =
𝑖=1 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡

∑𝑘
𝑖=1 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦𝑖,𝑡
∑𝑘
for all banks 𝑖 = {1,2, … , 𝑘} in the sample and for time periods t={1,2,…,T}.
𝑖=1 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡

3.4 Minus one bank risk measure

Aggregate Z-score is constructed by aggregating required data for all banks and thus it
shows extent of risk in the banking sector as a whole. Now to measure contribution of
individual banks’ risk taking towards the systematic risk in the sector, we can use “Leave one
out Z-score approach” or “Minus one bank Z-score measure” which is also used by (Li, Tripe,
Malone, & Smith, Measuring systemic risk contribution: The leave-one-out z-score method,
2020) They have used this approach on New Zealand banks to find out each bank’s contribution
towards the systematic risk present in the New Zealand banking sector.

The difference between performance of banking sector as a whole and performance of

banking sector excluding one bank at a time shows contribution of that bank towards the
systematic risk. In previous section while calculating aggregate Z-score measures, sample
consisted of total of 37 banks out of which 23 were public sector banks and 18 were private
sector banks. Sample period for the same was 2005-2022. But there were some major changes
in the composition of Indian banking sector after 2016. In public sector, we saw many mergers
among the banks. For example, on 1st April 2017, State bank of India merged with five of its
associate banks which were: State bank of Jaipur & Bikaner, Mysore, Travancore, Patiala and
Hyderabad. Similarly, on 1st April 2019, Vijaya bank and Dena bank were merged with Bank
of Baroda. Some other public sector banks also got merged during this time period. So before
these mergers or before 2016, there were 27 public sector banks(out of which our sample in
previous section consisted of 23 public sector banks), which after 2019 reduced to just 12
public sector banks. It was important to consider these merged banks separately while
calculating aggregate Z-score measures in previous section. But now when we want to assess
each banks’ contribution towards the systematic risk; by calculating minus one bank aggregate
Z-score, it would not make any sense to include those merged banks and work our calculations

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with that sample of banks which was used in previous section. So in this section, we restrict
our sample in a way such that it represents current banking sector. So we will only include
those banks which are present today in our sample. Out of 12 public sector banks, 10 of them
and 15 private sector banks currently present are part of the sample in this section. Since sample
is changed in this section, I have again calculated aggregate Z-score for this new sample of 25
banks as well.

Now to construct minus one Z-score for a particular bank- say 𝑗 𝑡ℎ bank, we will exclude
that bank from the portfolio and compute aggregate Z-score from the remaining portfolio of 24
banks. Then we will compare aggregate Z-score of portfolio of 25 banks and aggregate Z-score
of portfolio when excluding 𝑗 𝑡ℎ bank and see whether there is any significant change in the
distribution of two aggregate Z-score measures. The different between aggregate Z-score of
portfolio of 25 banks and aggregate Z-score of portfolio when excluding 𝑗 𝑡ℎ bank is the
contribution of 𝑗 𝑡ℎ bank towards the systematic risk of the banking sector.

Minus one bank aggregate Z-score for 𝑗 𝑡ℎ bank can be calculated as follow:

𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 [𝐶𝐴𝑟(−𝑗)]𝑡 + 𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒[𝑅𝑜𝐴(−𝑗)]𝑡

𝑀𝑖𝑛𝑢𝑠 𝑗 − 𝑏𝑎𝑛𝑘 𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝑍𝑡 =
𝜎[𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒(𝑅𝑜𝐴(−𝑗))]𝑡

Where

(∑𝑘𝑖=1 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡𝑠𝑖,𝑡 ) − 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡𝑠𝑗,𝑡

𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 [𝐶𝐴𝑟(−𝑗)]𝑡 =
(∑𝑘𝑖=1 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡 ) − 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠𝑗,𝑡
and

(∑𝑘𝑖=1 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦𝑖,𝑡 ) − 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦𝑗,𝑡

𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒[𝑅𝑜𝐴(−𝑗)]𝑡 =
(∑𝑘𝑖=1 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠𝑖,𝑡 ) − 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠𝑗,𝑡

for all banks 𝑖 = {1,2, … , 𝑘} in the sample and for time periods t={1,2,…,T}.

Definition of aggregate Z-score remains same as that of previous section, the only
change is that in this section I compute aggregate Z-score using sample of 25 banks.

10 | P a g e
3.5 Relationship between Demand Deposits and Z-score:

Banks’ main business has been to receive deposits from the public and lend it out to
those in need and earn return on it. So health of the banking sector is reflected by amount of
deposits in the banking system. During financial distress, amount of deposits fall in the banking
system: phenomenon which we call “Bank run” – when a large number of people rush towards
banks at the same time to withdraw their deposits in situations of financial distress. On the
other hand situation of financial distress is portrayed by decrease in Z-score. To check the
ability of Z-score to predict the financial distress, we want to find relationship between the Z-
score and amount of demand deposits in the banks. Question arises as to why I have picked up
demand deposits and not aggregate deposits which is the summation of demand deposits,
saving deposits and time deposits. Since saving deposits and time deposits pay interest and
they can be withdrawn only a certain number of times during the year(without incurring extra
charges), they tend to be less sensitive to the performance of bank. On the other hand, since
demand deposits are mostly held by businesses and corporations to meet their business
requirements, also demand deposits do not pay any interest, they tend to be more sensitive to
the bank’s performance in any given year. This is why in this paper I want to see the relationship
between demand deposits and Z-score. We would expect this relationship to be positive and
significant.

To check the ability of Z-score to predict financial distress in advance, I collected data
for demand deposit for sample of 30 banks (17 public, 13 private sector banks) and sample
period is 2005-2016. In the dataset, amount of deposits are in millions of INR. Then I have
used fixed effect Least Square Dummy variable model. (To determine whether to use fixed
effect or random effect model, all required tests are presented in section 4.4 of this paper)

ln(𝐷𝐷𝑖𝑡+1 ) = 𝛽1𝑖 + 𝛾1 ln 𝑍5𝑖𝑡 + 𝛾2 ln(𝐷𝐷𝑖𝑡 ) + 𝑢𝑖𝑡

for each bank 𝑖 =2,…,30 and for time period 𝑡 = 2005,2006,…,2016.

So dependent variable is Demand deposits of 𝑖 𝑡ℎ bank in time period (t+1) and

dependent variables are Z5 score and demand deposits of 𝑖 𝑡ℎ bank in time period (t).

11 | P a g e
4. Results

4.1 Individual bank Z-scores and their interpretations

In this paper, I have estimated individual bank Z-scores for all 31 public sector banks
and 21 private sector banks using all five approaches and table summarizing descriptive
statistics is provided at the end of this paper. As can be seen from the table, Z scores calculated
using approaches Z1 and Z2 are quite similar. One reason for this similarity is that both use
moving average and standard deviation estimates of RoA with window length equal to 3, while
these approaches differ only in their estimates of CAr. Z1 approach uses moving average of
CAr with window length equal to 3 whereas Z2 approach uses current period’s CAr value.
Similarly Z-scores calculated using approaches Z3 and Z5 are also quite similar. Again one
reason for this similarity is that both approaches use current period’s CAr and standard
deviation estimates of RoA calculated over whole sample period. The only difference, though
not a significant difference arises in estimation of CAr. Z3 uses current period’s CAr value
while Z5 uses mean of CAr calculated over the whole sample period. Approach Z4 is quite
different from all other approaches because it uses instantaneous standard deviation of RoA.
One probable difficulty with Z4 approach is that instantaneous standard deviation sometimes
might be some value very close to zero if difference between current period’s RoA and mean
of RoA is close to zero. This will lead to a very high value of Z4 score for that particular bank
which might be misleading.

For example, consider following table showing Z-scores for Bank of India.

Year Z1 Z2 Z3 Z4 Z5
2021 24.25336 22.53568 19.29364 107.7874 23.37639
2022 32.90641 32.70324 23.16151 1965.375 26.58946
Table 1: Z-scores for Bank of India

If we see change in Z4 between two years, it might seem that bank has done
exceptionally well and it is a safe heaven because Z4 has increased by a huge amount. But
when we see change in Z-scores using rest of the four approaches, we see that nonetheless bank
has performed well but it is not something miraculous. Reason for this high Z4 score was that
RoA in 2022 was almost same as the mean value of RoA calculated over the entire sample

12 | P a g e
which would imply a very low and close to zero value of instantaneous standard deviation of
RoA and thus a sharp increase in Z4 measure. So whenever we see any unusual change in Z4
score, we cannot straight away conclude from it and this is one disadvantage of this measure.
One of the remedies for this disadvantage of Z4 measure could be to use range of RoA defined
as Maximum RoA minus Minimum RoA over the sample period in place of instantaneous
standard deviation as a volatility measure. Nonetheless, theoretically Z4 measure is possible to
compute and to rely on it but it may not be the best measure to measure bank risk.

Z1 and Z2 are quite similar as I already discussed above. They both use moving average
and standard deviation estimates with window length equal to three years. So these approaches
compute estimates of mean and standard deviation of RoA using last three year’s values. This
way their estimates do not get affected by value of RoA (say) 7 years back. This might seem
practical too, that very past values of RoA (older than three years) should not affect current
value of Z score for the bank. These two approaches only take past three years’ values for RoA
to calculate Z score estimates and hence they can be termed as “Short-term measures of Z
score”, since they take into account only the recent past and they do not react to shocks that
might have happened long ago.

Sample: 2007 2017

Included observations: 484

Correlation
Probability Z1 Z2 Z3 Z4 Z5
Z1 1.000000
-----

Z2 0.997349 1.000000
0.0000 -----

Z3 0.157408 0.166282 1.000000

0.0005 0.0002 -----

Z4 0.003992 0.003706 0.155341 1.000000

0.9302 0.9352 0.0006 -----

Z5 0.151463 0.160455 0.999082 0.157751 1.000000

0.0008 0.0004 0.0000 0.0005 -----

Table 2: Correlation matrix

Above table shows coefficient of correlation between all five Z-score measures and
respective p-values. Z1 and Z2 are nearly perfect and positive correlation while Z1-Z3 and Z1-
Z5 have positive but weak correlation. Since p-value is greater than 0.05 for correlation
between Z1-Z4, Z1 and Z4 are uncorrelated. Similarly Z2-Z3 and Z2-Z5 have positive but

13 | P a g e
weak correlation while Z2 and Z4 are uncorrelated. At last, Z3 and Z5 are nearly perfectly
correlated with positive coefficient of correlation.

Contradictory to Z1 and Z2 measures, Z3 measure uses standard deviation estimates of

RoA calculated over the whole sample period while Z5 measure uses both mean and standard
deviation estimates for RoA calculated over the whole sample period. These two measure take
not only recent past but the whole sample period into account for computing Z scores. This
way they can be termed as “Long term measures of Z score”. Now question might arise that
when one should rely on short term measures and when one should rely on long term measures.
To answer this question, consider following example.

State Bank of
Mysore RoA CRAR Z1 Z2 Z3 Z5
2016 0.44 12.43 167.843 178.7521 13.94842 14.14517
2017 -2.29 12.41 7.254895 7.456247 10.96799 14.1235
Table 3: RoA, CRAR and Z-scores for State Bank of Mysore

State bank of Mysore (which has now been merged into SBI), as we can see it was
struggling during these periods as RoA was very close to zero in 2016 and it further dropped
down to negative value in 2017, together with more or less constant CRAR. Since Z3 and Z5
measures are considered to be long term measures by nature of their construction, it can be
seen that Z3 fell down a bit while Z5 remained more or less constant. These two measures have
failed to reflect worsened condition of the bank in 2017. One reason behind this can be that
instead of using mean value of RoA computed over last three years(Z1) or current value of
RoA(Z2), Z5 takes both mean and standard deviation estimate of RoA calculated over the entire
sample period and similarly Z3 takes standard deviation estimate of RoA calculated over the
whole sample. So Z3 and Z5 measures may be unable to reflect short term fluctuations in RoA
or CRAR very precisely because of the fact that they use estimates for the same variable
calculated over the entire sample. Since Z1 and Z2 take mean value of RoA calculated over
last 3 years and current value of RoA respectively, they are relatively a better at reflecting short
term fluctuations in RoA and CRAR and hence are able to show us true picture of banks’
stability affected by short term fluctuations in variables. This is also complimented by the fact
that both Z1 and Z2 had fallen drastically in response to considerably steep fall in RoA for this

14 | P a g e
bank, indicating that bank might not be doing well and bank risk has increased significantly in
the short run.

So advantages of Z1 and Z2 measures are that they are better measurement of bank risk
if short term period is considered. But when we want to look at banks’ risk for over a long term,
these measures may be very volatile and may not be of significant use. For example consider
following graph.

z1 z2 z3 z5
mean 99.95624 101.3483 39.66475 39.66475
std 44.69855 46.69907 2.427571 2.069171
obs 16 16 18 18
Table 4: Z-scores for State Bank of India

Z1 & Z2 measures for SBI Z3 & Z5 measures for SBI

200 50
45
150
40
Z-score
Z-score

100 35
30
50
25

0 20
2007 2009 2011 2013 2015 2017 2019 2021 2007 2009 2011 2013 2015 2017 2019 2021
Year Year

Z1 Z2 Z3 Z5

Figure 1: Z-score measures for State Bank of India

Figure A shows Z1 and Z2 measures while figure B shows Z3 and Z5 measures for SBI.
Table below shows the descriptive statistics for the same. As we can see from the figures, Z1
and Z2 measures are much more volatile than Z3 and Z5. The same can be verified by the fact
that standard deviations of Z1 and Z2 measures are significantly larger than that of Z3 and Z5.
Theoretically, Z1 and Z2 measures seem more practical as they take into account only recent
past, but empirically these measures are much volatile and are of less use when considering
studying bank risk over long periods of time. When period into consideration is long, say more

15 | P a g e
than 7 to 10 years, Z3 and Z5 approaches are more useful because they use all past information
and incorporate them into Z-scores to show an overall picture of bank’s stability.

To conclude this section, all different approaches to compute Z-score have their distinct
advantages as well as disadvantages. But we can follow thumb rule while assessing risk of a
bank that if our period of consideration is short than one can rely on Z1 or Z2 measures. On
the other hand if our period of consideration is long enough, say more than 5 years than one
can rely on Z3 or Z5 approaches.

4.2 Aggregate Z-score: Results

Aggregate Z Z1 Z2 Z3 Z4 Z5
Mean 188.3828 191.5722 17.79599 175.5104 17.79599
Std 296.3584 302.3951 1.381476 513.3524 1.645336
Obs 16 16 18 18 18
Figure 2: Descriptive statistics of Aggregate Z-score

Above table shows different aggregate Z-score measures for Indian banking sector.
Properties of different aggregate Z-score measures are same as the previous individual Z-score
measures. For example, aggregate Z5 is highly volatile while aggregate Z1 and Z2 (which can
here be considered as short term measures of systematic risk) are also quite volatile in nature.
If we want to analyse banking sector considering long time period, we may rely on aggregate
Z3 and Z5 measures since they are least volatile and takes into account all past information.
Aggregate Z3 and Z5 here can be considered as long term measures of systematic risk in the
sector.

16 | P a g e
 Aggregate Z3 & Z5 measures
22

20

18
Z-score

16

14

12
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
Year
Z3 Z5

Figure 3: Aggregate Z3 & Z3 measures

Above figure shows aggregate Z3 and Z5 measures over the sample time period. There
are few points that seem to be quite interesting. Global financial crisis of 2007-08 had its long
lasting impact all around the world but not of the same magnitude on Indian banking sector. As
we can see from the figure that before 2007, aggregate Z scores were coming down because
aggregate RoA had fallen from 1.40% in 2005 to 0.95% in 2006 while aggregate CAr remaining
more or less constant between the two years. As global financial crisis happened in the late
2007, Indian banking sector managed aggregate RoA of slightly more than 1% during 2007-10
while aggregate CAr actually increased from 5.54% in 2007 to 6.81% in 2008. It remained
around 6.5% till 2010. This together with aggregate RoA being 1% justifies the increase in Z-
score measures during 2007-08 in above figure. The fact that Indian banking sector managed
to achieve RoA of 1% during the times of global financial crisis is miraculous.

Aggregate RoA Aggregate CAr

1.5 9
Returns on Assets

Capital-Assets ratio

1 8
0.5
7
0
6
-0.5
5
200520072009201120132015201720192021
Year Year

Figure 4: Aggregate Returns to Assets & Capital to Assets ratio

17 | P a g e
 After the global financial crisis, Indian banking sector remained quite stable in the next
decade until 2016. We can see that both aggregate Z3 and Z5 measures were relatively stable
during the period 2009-16. Aggregate RoA remained around 1% till 2010 but then it started
falling as can be seen from figure a. Even though aggregate RoA was falling, reason for stability
in aggregate Z3 and Z5 measures can be attributed to the fact that during the same period
aggregate CAr was rising and which offset the negative impacts of falling aggregate RoA.

After 2016, aggregate Z3 measure showed downward trend as many public sector banks
during that time were facing huge losses and their RoAs were negative. For example, State
bank of Bikaner & Jaipur, State bank of Hyderabad, State bank of Mysore, State bank of
Patiala, State bank of Travancore and many other public sector banks had negative RoAs and
thus together with other reasons, above mentioned banks were merged with State bank of India
in 2017. Indeed aggregate RoA for the entire banking sector was negative during 2017 and
2018. After 2018 Indian banking sector started recovering which can be seen by rising
aggregate Z3 and Z5 measures in the figure.

4.2.1 Sector-wise comparison

Sector-wise aggregate Z-scores can be calculated just the same way as we have
calculated aggregated Z-score above. To do this, I have aggregated required data for public and
private sector banks separately and then used the same equations as above to calculate
aggregate Z-scores for public and private sector banks separately. Following table shows
descriptive statistics of sector-wise aggregate Z-score.

Aggregate Z
for public
sector Z1 Z2 Z3 Z4 Z5
Mean 134.725 134.5827 11.76642 67.66763 11.76642
Std 231.099 230.3122 0.820391 154.5408 0.404191
Obs 16 16 18 18 18
Table 5: Descriptive statistics pf Aggregate Z-score for public sector banks

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 Aggregate Z for
private sector Z1 Z2 Z3 Z4 Z5
Mean 84.91837 89.25919 21.88654 101.474 21.88654
Std 92.85358 101.979 3.410315 110.1185 3.4587
Obs 16 16 18 18 18
Table 6: Descriptive statistics of Aggregate Z-score for private sector banks

To compare public and private sector banks, we will focus on Z3 and Z5 measures as
they are more reliable because they take into account all past information and not only recent
past information. Both aggregate Z3 as well as Z5 measures for private sector are higher than
that of the public sector; implying that contribution of private sector into systematic risk is
lesser than that of the public sector banks. At the same time we can also notice that both
aggregate Z3 and Z5 measures are less volatile for public sector banks as compared to private
sector.

Aggregate Z3: Sector-wise

30

25

20
Z-score

15

10

5
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
Year

Aggregate Z3 Aggregate Z3-Public sector Aggregate Z3-Private sector

Figure 5: Sector-wise Aggregate Z3 scores

Above figure shows sector-wise aggregate Z3 measure. As we discussed earlier,

aggregate Z3 for private sector is much more volatile than that of public sector. Aggregate Z3
for public sector has stayed almost constant except for the years 2016-18. Question might arise
as to why aggregate Z3 for public sector has remained fairly constant even though as we argued
that during 2016-18 many public sector banks got merged because of high losses on their
balance sheets. Answer to this question is quite simple: During the same years, aggregate CAr

19 | P a g e
for public sector banks kept steadily increasing; offsetting the negative impacts of negative
RoAs and keeping aggregate Z3 for public sector more or less stable.

Now shifting our focus towards private sector we notice that aggregate Z3 for private
sector has been well above than aggregate Z3 for entire banking sector except for 2006-07 and
2017-18. During 2006-07, though aggregate RoA for private sector was well above 1.3% but
aggregate CAr dropped from 7.38% in 2005 to 5.11% in 2007. Similarly during 2017-18,
aggregate Z3 fell because of declining aggregate RoA and CAr in private sector. But from 2019
onwards, private sector has completely recovered and indeed grown much faster with aggregate
RoA being close to 2% and aggregate CAr as high as 11.31% in 2022.

Mean Std
Aggregate RoA 0.713325 0.425024
Aggregate RoA- Public sector 0.470939 0.545327
Aggregate RoA- Private sector 1.259745 0.465655
Table 7: Descriptive statistics of RoA

Aggregate RoA for public sector is significantly lower than that of private sector while
quite surprisingly, volatility of returns for public sector banks is also somewhat higher than that
of the private sector.

We can conclude this section by noting that contribution of public sector banks towards
systematic risk in the entire banking sector is higher than that of the private sector banks. This
conclusion is backed up by the fact that aggregate Z3 and Z5 measures for public sector have
been lesser than the aggregate Z3 and Z5 measures. Similarly aggregate Z3 and Z5 measures
for private sector have been well above the aggregate Z3 and Z5 measures indicating that
inclusion of public sector banks into calculation reduces the Z-scores; implying that there is
greater contribution of public sector banks towards the systematic risk.

4.3 Minus one bank aggregate Z-score: Results

In theory, minus one bank aggregate Z-scores are expected to be lower than that of
aggregate Z-score because of mitigation effect. This mitigation effect is same as the

20 | P a g e
 diversification effect. Thus removing particular bank from the portfolio to calculate minus one
bank aggregate Z-score would reduce the extent of mitigation effect and thus minus one bank
aggregate Z-score would in theory be lower than the aggregate Z-score. This means that
removing a bank from the portfolio leads to increase in aggregate Z-score; i.e. increase in
systematic risk.

But as we will now see that in real world, minus one bank aggregate Z-scores may not
be lower than the aggregate Z-score all the times. In fact there can be a case when minus one
bank aggregate Z-score for some bank may be higher than the aggregate Z-score; indicating
that removal of this particular bank from the portfolio actually leads to increase in aggregate
Z-score: i.e. reducing the systematic risk. Then that bank can be considered as quite risky and
it may be the case that because of that particular bank, aggregate Z-score is coming down;
indicating a higher systematic risk.

Following tables show descriptive statistics of aggregate Z-score (for this new sample
of 25 banks) and minus one bank aggregate Z-scores. Note that here I have used Z5 measure
as defined above to calculate both the scores.

(-
Aggregate (-SBI) (-BOM) (-BOB) (-BOI) CANARA) (-IOB) (-PNB) (-PSB) (-CBI) (-IB)

Mean 19.4684 19.76989 19.67649 19.68932 20.21199 19.92291 20.10504 20.60855 21.23835 19.61559 19.42576

Std 1.853539 2.207661 1.862197 1.959429 1.865309 2.011302 1.895948 2.070806 1.871859 1.891315 1.874928
%
change 1.548574 1.068826 1.13473 3.819477 2.334566 3.270097 5.856376 9.091364 0.756055 -0.21904
K-S p-
value 0.708768 0.944753 0.708768 0.218166 0.708768 0.218166 0.013717** 0.010041** 0.944753 0.999685
Table 8: Descriptive statistics of aggregate and minus one bank aggregate Z-scores for public sector banks

Aggregate (-AXIS) (-HDFC) (-ICICI) (-KOTAK) (-CUB) (-DCB) (-DB) (-FB) (-KB) (-KVB)

Mean 19.4684 12.87409 18.14281 17.50025 18.59981 19.42167 19.35652 19.48552 19.3579 19.30359 19.44554

Std 1.853539 1 1.391518 1.518512 1.630062 1.833861 1.82916 1.843043 1.834985 1.611604 1.852138
%
change -33.8719 -6.96384 -10.1095 -4.46153 -0.24007 -0.57467 0.087905 -0.56758 -0.84659 -0.11746
K-S p- 3.55E-
value 08*** 0.0029*** 0.001171*** 0.098181* 0.999685 0.999685 0.999685 0.999685 0.521339 0.999685

21 | P a g e
 Aggregate (-CSB) (-IDBI) (-JKB) (-YB) (-RBL)
Mean 19.4684 21.05318 20.85976 20.72181 20.52907 20.98664
Std 1.853539 1.203833 1.954321 1.872865 1.803074 1.855941
% change 4.597131 7.146732 6.438162 5.44816 7.798495
K-S p-
value 0.051467* 0.004263*** 0.081302* 0.081302* 0.010041**
Table 9: Descriptive statistics of aggregate and minus one bank aggregate Z-scores for private sector
banks

*** = significance at 1% level; ** = significance at 5% level; * = significance at 10% level

1 (𝑀𝑖𝑛𝑢𝑠 𝑗−𝑏𝑎𝑛𝑘 𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝑍𝑡 )−(𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝑍𝑡 )

Here % change = ∑𝑇
𝑡=1 𝑇 [ ]. %
(𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝑍𝑡 )

change for a particular bank shows its contribution towards the systematic risk. In theory as we
discussed above, % change should be negative indicating higher systematic risk while dropping
a bank from the portfolio. To compare between the distributions of aggregate Z-score and
minus one bank aggregate Z-score, apart from % change, I have further used non-parametric
Kolmogorov-Smirnov (K-S) test. The K-S statistics quantifies the distance between the
empirical distribution function of the sample(which is minus j-bank Aggregate Z) and the
cumulative distribution function of the reference distribution(which is Aggregate Z here).

K-S test:

𝐻0 : sample is drawn from the reference distribution.(No significant difference between

the two samples.)

Statistical significance would imply that distribution of minus 𝑗 𝑡ℎ bank aggregate Z

score is significantly different from the distribution of aggregate Z -score, implying that
removal of 𝑗 𝑡ℎ bank from the portfolio leads to significant changes in systematic risk in the
banking sector. These changes in systematic risk may be positive or negative as we will see
next.

Table a and b show descriptive statistics, % change and K-S p-values for public sector
banks and private sector banks respectively. We see that out of 10 public sector banks, % change
for 9 of them is positive; indicating that these public sector banks cause systematic risk to
increase in the Indian banking sector. But we should acknowledge that even though % change
for 9 of these public sector banks is positive, for majority of them % change is quite low around

22 | P a g e
1-3% only. Also by looking at K-S p-values, out of 10 public sector banks, p-values for 8 of
these banks is greater than 0.10; so that we are unable to reject the null hypothesis of K-S test
and hence for 8 of these banks, there is no significant difference between the distribution of
minus one aggregate Z-score and aggregate Z-score. But for two public sector banks, namely
PNB- Punjab National Bank and PSB- Punjab & Sind Bank; % change is positive and greater
than 5%, also K-S p-values for these banks are significant implying that there is significant
difference between the distributions of minus one bank aggregate Z-score for these two banks
and distribution of aggregate Z-score. These two banks may be considered as systematically
significant banks due to whom systematic risk is increased in the system. Here we need to
define systematically significant bank more clearly: systematically significant bank is the one
for whom distribution of minus one aggregate Z-score is significantly different from the
distribution of aggregate Z-score (for whom K-S test null hypothesis is rejected).
Systematically significant bank may be the one due to whom systematic risk might have
increased in the system (e.g. PNB or PSB) while on the other hand, it may be the one due to
whom systematic risk might have decreased in the system (e.g. HDFC or ICICI).

In the private sector, for few of them % change is negative(as desired) while for few of
them % change is positive. Axis bank, ICICI bank, Kotak Mahindra bank and HDFC bank are
those systematically significant banks due to whom systematic risk is reduced in the system,
which is further justified by the fact that out of these four banks, ICICI and Kotak Mahindra
Banks are indeed in the list of Domestic Systematically Important Banks published by RBI.
For all these four banks, we reject the null of K-S test; implying that for these four banks
distribution of minus one aggregate Z-score is significantly different from the distribution of
aggregate Z-score. On the other hand there are few banks like IDBI bank and Yes bank due to
whom systematic risk is increased in the system(indicated by positive % change and accepting
of K-S test null hypothesis).

23 | P a g e
4.4 Relationship between Demand deposits and Z-score

Dependent variable ln(𝐷𝐷𝑖𝑡+1 ) is stationary at level and its unit root test is given in the
appendix. To check whether pooled ordinary least square (POLS) is better or fixed effect least
square dummy variable (LSDV) is better, I have used redundant fixed effect test.

Redundant fixed effect test:

𝐻0 : Effects are redundant (POLS is better.)

𝐻1 : Effects are significant (LSDV is better.)

Redundant Fixed Effects Tests Correlated Random Effects - Hausman Test

Equation: Untitled Equation: Untitled
Test cross-section and period fixed effects
Test cross-section and period random effects
Effects Test Statistic d.f. Prob.
Test Summary Chi-Sq. Statistic Chi-Sq. d.f. Prob.
Cross-section F 6.928957 (29,288) 0.0000
Cross-section Chi-square 174.662003 29 0.0000
Period F 5.681901 (10,288) 0.0000 Cross-section random 152.978110 2 0.0000
Period Chi-square 59.419533 10 0.0000 Period random 0.000000 2 1.0000
Cross-Section/Period F 5.540471 (39,288) 0.0000
Cross-Section/Period Chi-square 184.724516 39 0.0000 Cross-section and period random 173.788323 2 0.0000

Test 1: Redundant Fixed Effects Test Test 2 : Hausman Test

First I have run POLS on above equation and then I have run this test. Above is its result
and as we can see all p-values are less than 0.01, we reject the null hypothesis. Both cross
section and time effects are significant and it is better to use LSDV model.

Now to check whether to use fixed effect of random effect model, I have used Hausman
test.

Hausman test:

𝐻0 : Random effects model is preferred.

𝐻1 : Fixed effect model is preferred.

I have run above regression keeping both cross-section as well as time effects to be
random. Table b shows result of this test. We can see that p-value is less than 0.01 for cross
section and period random; so that we reject the null hypothesis and thus fixed effect model is
preferred.

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 Finally I run fixed effect LSDV model as described above while keeping both cross
section and time effects as fixed. So I have used two way fixed effects model to allow intercepts
to differ across banks (cross section effect) as well as time. While slope coefficient is same
across all banks in this model. Following are the results:

Dependent Variable: LNDD1

Method: Panel Least Squares
Date: 06/02/23 Time: 20:51
Sample (adjusted): 2005 2015
Periods included: 11
Cross-sections included: 30
Total panel (balanced) observations: 330

Variable Coefficient Std. Error t-Statistic Prob.

C 4.788899 0.808041 5.926552 0.0000

LNDD 0.406546 0.042460 9.574859 0.0000
LNZ5 0.603578 0.226230 2.667988 0.0081

Effects Specification

Cross-section fixed (dummy variables)

Period fixed (dummy variables)

R-squared 0.944364 Mean dependent var 11.00316

Adjusted R-squared 0.936444 S.D. dependent var 1.427861
S.E. of regression 0.359969 Akaike info criterion 0.912816
Sum squared resid 37.31840 Schwarz criterion 1.396337
Log likelihood -108.6147 Hannan-Quinn criter. 1.105686
F-statistic 119.2319 Durbin-Watson stat 2.368563
Prob(F-statistic) 0.000000

Coefficients of both our independent variables are significant at 99% level of

significance and both of them are positive. It is obvious that coefficient of ln(𝐷𝐷𝑖𝑡 ) which is
𝛾2 to be positive; indicating that on an average for any given bank, this period’s demand
deposits will have a positive impact on next period’s demand deposits thus showing stability
in banks. Now coming to our main purpose of finding relationship between banks’ demand
deposits and their respective Z-scores: Coefficient of ln 𝑍5𝑖𝑡 which is 𝛾1 is positive and
significant as expected. That there is a positive relationship between a bank’s demand deposits
and its Z-score. 𝛾1 = 0.603578 in this model would imply that on an average 1% change in
Z5 measure would lead to 0.603578% change in demand deposits next period.

This period’s Z-score positively affects next period’s demand deposits of particular
bank, e.g. if for some reason this period’s Z-score falls by 1 %, this model predicts that on
average it will lead to fall in demand deposits by 0.603578%. This way Z-score may be used
to predict the financial distress in advance.

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5. Conclusion

This paper’s aim has been to apply different methodologies of calculating Z-score to
assess individual bank’s risk and systematic risk in the Indian banking sector for a period of
2005-2022. Period of 2005-2022 has been very crucial for Indian banking sector for a number
of reasons: 1) This period includes 2007-08, period when entire world was impacted by
Global Financial Crisis. Using Z-score we have seen in section 4.2 that quite miraculously
Indian banking sector managed aggregate RoA of slightly more than 1% during 2007-10
while aggregate CAr actually increased from 5.54% in 2007 to 6.81% in 2008. This
phenomena was also reflected in increase in aggregate Z-score; implying reduced systematic
risk in the system. 2) This period includes 2016-2019, during these three years, public sector
banks were performing very poorly, majority of banks had negative returns on assets because
of huge losses incurred during this period. Aggregate RoA for entire banking sector was
negative during 2017 and 2018. During this period many public sector banks got merged with
other public sector banks, thus currently in 2022, there are only 12 public sector banks.
During this same period, some of the private sector banks were also performing poorly. Poor
performance of banking sector was the reason behind decrease in aggregate Z-score during
this period which indicated increased systematic risk in the system.

In section 4.2.1, our study has found that aggregate Z-score for public sector banks
has been consistently lower than the aggregate Z-score for the system as a whole; indicating
that public sector banks may have caused systematic risk to increase in the system during the
sample period 2005-2022. Since aggregate Z-score for private sector banks has been
higher(except for 2007) & aggregate Z-score for public sector banks has been lower than the
aggregate Z-score for banking sector as a whole; we can infer that private sector banks have
been able to outperform the public sector banks and that public sector banks have been riskier
than the private sector banks on average. Also mean value of aggregate RoA for public sector
banks during the sample period is 0.47% which is significantly lower than the mean value of
aggregate RoA for private sector which is 1.25%. Also returns of public sector banks on
average have been slightly more volatile than that of the private sector banks(refer table 7;
standard deviation of RoA for public sector banks is slightly higher than that for private
sector banks). This way I have applied Z-score to compare between the two sectors and to
assess each sector’s contribution towards systematic risk.

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 In section 4.3, we have used minus one bank aggregate Z-score measure to find each
individual bank’s contribution towards the systematic risk. While in section 4.4 we tried to
assess predictive ability of Z-score in financial distress. We found that for a particular bank,
for a 1% decrease in Z-score this period(implying higher bank’s risk of insolvency), our
model predicts that demand for deposits in the next period would fall by 0.60%(system-wide
fall in demand deposits is indicator of financial distress). So that if we observe system-wide
decrease in this year’s Z-score, we would be able to predict system-wide decrease in next
year’s demand deposits; or in other words we would be able to predict financial distress in
advance.

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References

Altman, E. I. (1968). Financial Ratios, Discriminant Analysis and the Prediction of Corporate
Bankruptcy. The Journal of Finance, 589-609.
Boyd, J. H., Nicolò, G. D., & Jalal, A. M. (2006). Bank Risk-Taking and Competition
Revisited: New Theory and New Evidence. International Monetary Fund.
George G. Kaufman, K. E. (2003). What is Systematic Risk, and Do Bank Regulators Retard
or Contribute to It? The Independent Review, 371-391.
Hesse H, Č. M. (2007). Cooperative Banks and Financial Stability. IMF Working Paper.
IJtsma, P., Spierdijk, L., & Shaffer, S. (2017). The concentration–stability controversy in
banking: New evidence from the EU-25. Journal of Financial Stability.
Lepetit, L., & Strobel, F. (2014). Bank insolvency risk and time-varying Z-score measures.
Journal of International Financial Markets, 73-87.
Li, X., Tripe, D., & Malone, C. (2017). Measuring bank risk: An exploration of z-score.
Li, X., Tripe, D., Malone, C., & Smith, D. (2020). Measuring systemic risk contribution: The
leave-one-out z-score method. Finance Research Letters.
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Banking Sectors: Impact on Competition and Risk. Journal of Banking and Finance,
1633-1647.

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Appendix

A1: Individual Z-scores for Public Sector Banks

Public Sector Banks Z1 Z2 Z3 Z4 Z5

mean 336.0854 326.6104 21.59587 67.1285 21.59129
State Bank of Bikaner std 266.849 253.0131 3.456254 28.65469 2.602121
obs 11 11 13 13 13
mean 108.8808 109.838 18.33171 118.5841 18.33171
State Bank of Hyderabad std 58.52907 64.72057 2.106343 191.6995 1.554955
obs 11 11 13 13 13
mean 99.95624 101.3483 39.66475 310.0348 39.66475
State Bank of India std 44.69855 46.69907 2.427571 766.076 2.069171
obs 16 16 18 18 18
mean 112.3032 114.024 13.8042 83.12564 13.8042
State Bank of Mysore std 54.32527 57.70495 1.247104 102.2805 0.811068
obs 11 11 13 13 13
mean 196.6823 195.1972 12.08672 97.74328 12.08672
State Bank of Patiala std 185.697 187.6598 1.881164 227.895 1.152313
obs 11 11 13 13 13
mean 199.4501 209.4426 16.41477 59.35006 16.41477
State Bank of Travancore std 291.4766 316.1715 2.034466 63.47302 1.503779
obs 10 10 13 13 13
mean 73.18405 71.80521 7.994437 20.81073 7.994437
Allahabad Bank std 65.43561 63.45435 1.559974 22.64994 0.899914
obs 14 14 16 16 16
mean 80.14285 80.46797 13.74721 23.19205 13.74721
Andhra Bank std 55.81247 57.91456 1.943206 12.40394 1.345496
obs 14 14 16 16 16
mean 258.7901 269.4546 24.27408 65.85623 24.27408
Bank of Baroda std 589.8671 634.9205 2.383933 97.63184 1.895254
obs 16 16 18 18 18
mean 57.70095 57.50546 19.60835 161.4947 19.60835
Bank of India std 51.45656 51.32903 2.498361 455.0509 2.549349
obs 16 16 18 18 18
mean 113.6273 117.255 13.7064 82.71753 13.61416
Bank of Maharashtra std 174.2399 183.0418 2.061862 151.9554 1.553849
obs 16 16 18 18 18
mean 70.42133 71.6377 21.36877 174.6176 21.36877
Canara Bank std 55.62485 58.57161 2.62936 440.1043 2.177491
obs 16 16 18 18 18
mean 51.24087 52.17184 15.30179 26.198 15.30179
Central Bank of India std 40.61191 43.94749 2.671725 15.19468 2.085363
obs 16 16 18 18 18
mean 151.8759 152.6451 9.999916 62.78872 9.999916
Corporation Bank std 175.6859 186.286 2.118223 114.3078 1.387471
obs 14 14 16 16 16
mean 197.7117 202.6243 6.325964 17.11703 6.325964
Dena Bank std 381.7773 400.3972 2.437768 11.76568 1.499888
obs 13 13 15 15 15

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 mean 116.4312 116.6895 28.16499 44.98055 28.16499
Indian Bank std 132.5513 128.4254 2.119612 35.66482 2.037547
obs 16 16 18 18 18
mean 91.05091 88.1597 9.527059 23.08482 9.527059
Indian Overseas Bank std 134.8269 129.1284 2.312961 19.64296 1.496822
obs 16 16 18 18 18
mean 71.83718 72.01496 12.10021 30.92407 12.10021
Oriental Bank of
Commerce std 61.06763 61.38544 1.599836 24.76053 1.132216
obs 14 14 16 16 16
mean 53.37896 53.3384 13.31346 52.26195 13.31346
Punjab and Sind Bank std 31.31331 30.04917 2.434511 76.67083 2.296879
obs 16 16 18 18 18
mean 88.51161 87.73109 14.55167 58.85827 14.55167
Punjab National Bank std 87.54321 84.85063 2.542225 133.684 1.769012
obs 16 16 18 18 18
mean 139.1157 139.9166 15.71456 25.79241 15.71456
Syndicate Bank std 186.4609 188.3202 1.419705 14.14816 1.172296
obs 14 14 16 16 16
mean 61.14159 61.83902 13.22901 33.6042 13.22901
Uco Bank std 53.89755 54.65177 2.138144 56.02213 1.40584
obs 6 16 18 18 18
mean 146.339 145.1366 18.6155 290.6184 18.6155
Union Bank of India std 336.5277 330.1118 2.014406 950.5341 1.548203
obs 16 16 18 18 18
mean 67.66685 65.19451 9.000988 23.78516 9.000988
United Bank of India std 88.94043 82.84177 2.741663 23.5583 1.947704
obs 14 14 16 16 16
mean 127.7459 129.7655 22.43351 172.9676 22.43351
Vijaya Bank std 94.21042 98.67171 2.676941 326.1795 2.045499
obs 13 13 15 15 15
Table 10- Descriptive Statistics of Z-score for private sector banks

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A2: Individual Z-scores for private sector banks

Private Sector Banks Z1 Z2 Z3 Z4 Z5

mean 373.153 384.256 29.30286 362.2054 29.30286
Axis Bank std 708.6806 717.4811 3.928186 812.2777 4.106739
obs 16 16 18 18 18
mean 68.02969 69.18914 19.99192 152.9246 19.99192
CSB Bank std 78.91352 77.28618 7.622144 217.261 7.069228
obs 16 16 18 18 18
mean 378.0986 380.6601 91.05368 361.3657 91.05368
City Union Bank std 715.936 708.4493 13.663 402.0709 14.16307
obs 16 16 18 18 18
mean 123.731 129.6671 11.14771 35.42709 11.14771
DCB Bank std 154.8726 164.8231 2.783208 56.44534 2.078265
obs 16 16 18 18 18
mean 34.43382 34.48332 12.83332 34.78578 12.83332
Dhanlaxmi Bank std 25.62526 25.15728 3.392679 43.17423 2.674911
obs 16 16 18 18 18
mean 192.1698 198.9188 56.60856 84.81159 56.60856
Federal Bank std 124.7352 137.0209 9.872514 68.44852 9.262988
obs 16 16 18 18 18
mean 333.5822 345.8139 62.99401 99.82743 62.99401
HDFC Bank std 209.7193 223.0047 8.529634 101.9591 7.826505
obs 16 16 18 18 18
mean 106.5549 110.1872 45.80064 196.3259 45.80064
ICICI Bank std 64.351 69.80107 6.687046 366.6283 6.435646
obs 16 16 18 18 18
mean 248.0634 228.6896 7.251212 12.80825 7.251212
IDBI std 601.3617 535.2151 1.869361 5.451257 1.239681
obs 16 16 18 18 18
mean 164.4586 168.5242 26.8466 132.8126 26.8466
IndusInd Bank std 194.8564 200.4284 4.086724 353.8402 3.585433
obs 16 16 18 18 18
mean 74.43251 74.94829 14.5479 72.95119 14.5479
Jammu & Kashmir Bank std 82.92106 85.89273 2.12328 94.14773 1.390148
obs 16 16 18 18 18
mean 184.5948 189.5665 47.74683 91.31732 47.74683
Karnataka Bank std 168.7383 181.4831 3.654726 76.90927 3.842472
obs 16 16 18 18 18
mean 124.1562 124.6585 32.24214 48.63768 32.24214
Karur Vysya Bank std 63.07407 61.28255 3.797028 29.35551 4.086708
obs 16 16 18 18 18
mean 278.7068 285.3015 55.82162 109.308 55.82162
Kotak Mahindra Bank std 347.3035 358.8679 9.039832 74.49684 8.585367
obs 16 16 18 18 18

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 mean 56.6774 55.83052 9.603909 35.42347 9.603909
Lakshmi Vilas Bank std 34.22955 36.3791 3.557941 56.40419 2.716637
obs 14 14 16 16 16
mean 92.12235 93.25938 22.40409 47.85013 22.40409
Nainital Bank std 58.81565 61.96627 2.209268 49.20672 1.697758
obs 16 16 18 18 18
mean 84.91044 83.51397 34.07445 102.2812 34.07445
RBL Bank std 68.17996 70.3222 20.44364 142.4284 20.1352
obs 16 16 18 18 18
mean 278.9614 282.1434 33.82654 58.87839 33.82654
South Indian Bank std 331.3519 333.9053 4.09757 47.33656 3.8309
obs 16 16 18 18 18
mean 161.6129 159.1094 45.40066 474.8747 45.40066
Tamilnad Mercantile Bank std 147.7526 143.565 6.239666 1600.573 5.936075
obs 16 16 18 18 18
mean 424.291 432.6807 9.55333 22.76962 9.55333
Yes Bank std 829.0094 858.7725 2.20725 10.39818 1.470151
obs 16 16 18 18 18
Table 11- Descriptive Statistics of Z-score for private sector banks

A3: Unit root test on dependent variable

Panel unit root test: Summary

Series: LNDD
Date: 06/03/23 Time: 22:48
Sample: 2005 2016
Exogenous variables: Individual effects
User-specified lags: 1
Newey-West automatic bandwidth selection and Bartlett kernel
Balanced observations for each test

Cross-
Method Statistic Prob.** sections Obs
Null: Unit root (assumes common unit root process)
Levin, Lin & Chu t* -10.0121 0.0000 30 300

Null: Unit root (assumes individual unit root process)

Im, Pesaran and Shin W-stat -2.21440 0.0134 30 300
ADF - Fisher Chi-square 83.5647 0.0239 30 300
PP - Fisher Chi-square 186.696 0.0000 30 330

** Probabilities for Fisher tests are computed using an asymptotic Chi

-square distribution. All other tests assume asymptotic normality.

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