Determinants of Asset Quality in the Indian Banking Sector: An Application of the Multidimensional Index

Abstract

Asset quality is an important indicator of the stability of the banking sector, which in turn can potentially affect the stability of an economy. Hence, understanding factors that affect the bank’s asset quality can have significant policy implications. This article aims at identifying the factors that affect the asset quality of a bank after controlling for macroeconomic variables, that is, annual GDP growth rate, inflation rate and macroeconomic shocks such as the global financial crisis and the COVID-19 pandemic. To this end, we construct multidimensional indices of bank-specific variables and use them to find the determinants of asset quality. The article also uses election year dummies to capture the effect of potential political influence on asset quality. We use unbalanced panel data for 51 banks over the period of 18 years (2006–2023). The empirical results reveal that earnings, liquidity and operational efficiency have a significant impact on asset quality. The significant coefficients of election dummies reflect the consequence of evolving policies undertaken and the ongoing political affairs at that time. The article also extracts some important policy implications for better governance of the asset quality of a bank.

JEL Classification: G21, D72, E44, E58, C43, C36