Macro Stress Testing andResilience Assessment of
Indian Banking
Pami DuaDirector, Delhi School of Economics
Chairperson, Research CouncilDean, Academic Activities
University of Delhi
October 20, 2016
Objective
Background
Four Pronged Strategy
Macro Stress Testing (MST)
Resilience Assessment (RA)
Empirical Model
Data and Methodology
Estimation Results
Policy Implications
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To conduct Macro Stress Testing (MST) and examine resilience of the Indian Banking Sector to various shocks
How a shock is expected to impact stability of Banking Sector measured by Financial Soundness Indicators
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Episodes of Financial Crises highlighted
expanding role of Macro-Prudential Policy which:
Captures interrelationship between financial institutions,
financial sector and the economy
Reflects macro-financial links or channels and
Has implications for banking sector regulations
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Background (past episodes) . . 1/7
Financial Stability (FS) is now an added objective in
monetary and macroeconomic policy (one of the statutory
objective of central banks) across the world:• Requires policymakers to incorporate macro-financial channels for
formulation of any successful monetary policy
• To ensure FS, Macro Stress Testing (MST) and Resilience Assessment (RA)
are integral part of macro-prudential tools
• Since banks are more vulnerable to deterioration in the overall macro-
financial environment due to adverse impact of shocks, maintaining
resilience to risk and shock is an integral part of bank management, bank
regulation and supervision.
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Background (Financial Stability) . . 2/7
Role of Regulators: BASEL Norms• Basel Committee on Banking Supervision (BCBS) set up by the Bank of
International Settlements (BIS) proposed the BASEL accord in 1988
• Accord prescribed a set of minimum capital requirements of 8% for
banks to reduce credit (default) risk -- BASEL I international norms
• BASEL II and III upgraded BASEL I norms and involved the buildup of
banks’ resilience to shocks by maintaining additional Capital
Conservation Buffers (CCB), thereby ensuring both quantity and quality
[total (k) and Tier I (k1)] of capital adequacy by banks.
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Background (BASEL Norms) . . 3/7
Capital Adequacy Ratio: Ratio of Capital to Risk Weighted Assets
KAR = K/RWA
K = Tier 1 K + Tier 2 K
Tier 1 K (k1): Core Capital -- component of regulatory capital which is considered to be of the highest quality because it is fully and readily available to cover losses. It mainly comprises share capital and disclosed reserves.
Tier II K (k2): Additional or Supplementary Capital over and above Tier I. It comprises certain reserves and types of subordinated debts.
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Background (Capital Adequacy Ratio) . . 4/7
Risk Weighted Assets are weighted sum of assets: prescribed risk
weights are assigned to different types of assets according to
BASEL norms:
RWA = 0%*Bucket 1 + 20%*Bucket 2 + 50%*Bucket 3 + 100%*Bucket 4
Bucket 1, 2, 3 and 4 indicate assets with zero, low, medium and high
default risk with weights (0, 0.2, 0.5, 1) respectively
Capital Conservation Buffer (CCB) provides additional capital
buffer to enable banks to meet unexpected losses due to shocks
without breaching the minimum 8% KAR norm.
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Background (Capital Adequacy Ratio) . . 5/7
9
BASEL I(International
norm)
BASEL II(International
norm)
BASEL II( Current RBI
norm)
BASEL III(International
norm as on 1.1.2019)
BASEL III(RBI norm as
on 31.3.2018)
1 Minimum k 8 8 9 8 9
2 Minimum k1 - 4 6 6 7
3 Maximum k2 - 4 3 2 2
4 CCB - - - 2.5 2.5
5 K + CCB 8 8 - 10.5 11.5
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BASEL Norms for Total & Tier 1 Regulatory Capital Adequacy Ratio
Background (BASEL Norms) . . 6/7
BASEL* I (1988,94) II (2006,08) III (2019,18)
International 8 8 (4+4) 8 (6+2)+2.5India 8 9 (6+3) 9 (7+2)+2.5
BASEL I (International, Indian) =(1988, 1994)
BASEL II (International, Indian) =(2006, 2008)
BASEL III (International, Indian) =(2019, 2018)
8 = Total KAR (k)
4+4 = Tier I K (k1) + Tier II K (k2), introduced in BASEL II
6+2 = Tier I K (k1) + Tier II K (k2), modified in BASEL III
2.5 = CCB introduced in BASEL III.
BASEL III requires 10.5% KAR = Total ( Tier I (k1) + Tier II (k2)) + CCB = 8 (6+2) + 2.5
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BASEL Norms for Total & Tier 1 Regulatory Capital Adequacy Ratio
Background (BASEL Norms) . . 7/7
An integrated approach using scenario analysis for India to conduct–
• Macro Stress Testing (MST)
and
• Resilience Assessment (RA)
of Indian Banking in compliance with BASEL II and III
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Figure 1 : Four Pronged Strategy (MST & RA)
Conduct Resilience Assessment (RA)
STEP 1: Identification of a shock/stress event and Scenario AnalysisBased on Historical and/or Hypothetical Scenarios
(Mapping the impact of stress event on key macroeconomic variables)
STEP 2: (Empirical) Macro-financial Model
(Mapping the impact of stressed macroeconomic variables on Bank credit quality indicator)
STEP 3 : Examine Impact on Expected Banking Losses
STEP 4: Examine Impact on Financial Soundness Indicator (as per BASEL norms)
ConductMacro Stress Testing(MST)
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Figure 2: A Simple Sketch of MST & RA Framework
Initial shock/Adverse macro-economic scenario(Historical or Hypothetical)
Macro-econometric
Model
Impact on macro
economic variable
eg. Slow down in output,
rise in unemployment
Macro Credit Stress
Testing Model
Borrower default and
credit quality
deterioration
Mapping defaults into
(expected) Credit Loss
Impact on Balance Sheet
in terms of Profit and
Capital
Threshold for Bank failurein terms of
BASEL Norms
Internal Rating based
approach
Resilience Assessment
Examine impact of Policy-based shocks and other external shocks on credit quality of banks to conduct MST and RA
Model Probability of Default as a measure of Credit Quality as a function of key macroeconomic variables.
Conduct Scenario Analysis based on simulation experiments of a SMEM for India - Historical scenarios and two types of Hypothetical scenarios (moderate and severe). Historical Scenarios explicitly capture the impact of policy measures and other
external shocks on the economy’s growth rate using a model which incorporates sufficient policy levers and global transmission channels for an integrated economy.
Assess the resilience of the Indian banks to shocks by examining the impact of stressed credit quality (due to shocks) on the KAR (total and Tier I).
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Application to India – MST and RA .. 1/6
STEP 1. Designing of Scenarios
Historical:‘A SMEM For INDIA’, Dua and Kapur (2015)
Hypothetical:Zeman and Jurca (2008), NBS (Type I)FSR, RBI on MST (Type II)
STEP 2. Model
Macroeconomic credit risk model- based on Wilson (1997)
PD = f (output growth, inflation rate, interest rate, exchange rate)
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Application to India – MST and RA .. 2/6
EMPIRICAL MODEL:
Expected impact of Variables included in the analysis on NPA ratio (N)
16
Indicator Variable Name Expected Sign
1. Cyclical y -
2. Price Stability π or m -
3. Financial i +
4. External e -/+
N = f (y, m, i, e).
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Application to India – MST and RA .. 3/6
Source : Sample data 1997Q2 - 2013Q2
STEP 3. Estimation of credit risk losses
17
𝑪𝑳𝒕+𝟏 = 𝑵𝒕+𝟏 × 𝑳𝑮𝑫𝒕 × 𝑬𝑨𝑫𝒕 (2)
20-Oct-16 Macro Stress Testing and Resilience Assessment of Indian Banking
Credit losses are calculated in period t+1 given the estimated NPA ratio (obtained in step 2 as an estimate of probability of default due to stressed GDP growth rate due to shock) , loss given default (assumed in period t) and exposure at default in period t (which is loan amount outstanding over and above NPAs in period t, exposed to default).
Application to India – MST and RA .. 4/6
STEP 4. Impact on the KAR
18
𝒌𝒕+𝟏 = 𝑲𝒕 + 𝒑𝒓𝒐𝒇𝒊𝒕𝒕+𝟏 − 𝑪𝑳𝒕+𝟏
𝑹𝑾𝑨𝒕 − 𝜟𝑵𝑷𝑨𝒕+𝟏 (𝟑)
20-Oct-16 Macro Stress Testing and Resilience Assessment of Indian Banking
Finally, KAR (k) is calculated using total capital, profits net of credit losses (calculated in step 3) divided by RWA net of changes in NPAs. Similarly, calculation of Tier I (k1) is also done by just replacing total capital by Tier I capital in the numerator.
Application to India – MST and RA .. 5/6
PD = avg % of obligers that default (N)
LGD = % of exposure that bank might lose in case of default by borrower(0<LGD<100%)
Under Basel II, Internal Rating Based (IRB) approach, we have two options: (a) Foundation IRB (FIRB), in which we model PDs, while LGD and EAD are given and (b) Advanced IRB in which banks estimate all inputs, i.e., PD, EAD as well as LGD.
We assume FIRB and LGD =100% (a prudent assumption)
EAD = estimate of the amount outstanding in case borrower defaultsNPA = amount (principal) or interest is overdue for at least 90 daysNPA ratio (N) = Gross NPAs / Gross advances
KAR = K/RWA
K = Tier 1 K + Tier 2 K
RWA = 0(B1) + 0.2(B2) +0.5(B3) +1(B4)
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Application to India – MST and RA .. 6/6
Reserve Bank of India Ministry of Statistics & Programme
Implementation IMF International Financial Statistics (IFS) OECD Statistics CMIE monthly Bulletin on Indian Economy.
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Data Sources
Unit Root Tests: All series are I(1) or non-stationary.
VEC Model: Cointegration exists between NPA ratio, growth rate ofIndian GDP, growth rate of broad money supply (M3), interest rate(nominal GS 10 yield rate) and exchange rate (nominal vis-à-vis USD).All signs conform to expectations.
Granger Causality: Null of no Granger causality from the factors to NPAratio is significantly rejected at 1% level for all the variables.
Generalized impulse response functions reveal that shocks to allvariables affect the NPA ratio.
Normalized generalized variance decompositions suggest thatimportant determinants of NPA ratio, in decreasing order ofimportance, are as follows: GDP growth rate, money growth rate,exchange rate and interest rate.
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Estimation Results
N = f (y, i, m, e)
22
𝑵−𝟏 = −𝟏. 𝟑𝟔𝟎𝐲−𝟏 + 𝟎. 𝟓𝟏𝟒𝒊−𝟏 − 𝟎. 𝟖𝟐𝟑𝒎−𝟏 − 𝟎. 𝟒𝟑𝟖𝒆−𝟏 + 𝟒𝟕. 𝟖𝟔𝟐
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Long run relationship in the VECM
Results on Scenario Analysis
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Impact Analysis of Macro Credit Stress Testing Impact of stressed economy’s growth rate on NPA ratio
Impact Analysis of Resilience of Indian Banking Sector Impact of stressed NPA ratio on total KAR (k) and Tier I (k1).
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Policy Based & External Shocks
A Monetary Policy shock (say, an ↑ in Repo rate impulse (one time) shock reduces the real GDP growth rate (based on simulation experiments of SMEM; Historical scenarios) initially in 2010-11 to 7.91% as compared to baseline scenario at 8.13% and then increases relative to baseline to sustain growth rate to levels prior to the shocks in around two years. The slowdown in economy’s growth rate causes an increase in NPA ratio (N), i.e. Credit Quality worsens.
A step (sustained or permanent hike) shock, however, is expected to be more effective and adversely impacts the growth rate in economy. The impact on N is also more adverse for a step shock.
25
SCENARIOS POLICY-BASED SHOCKS
Year Baseline
(1)
Monetary Policy
(2)
y N y N
2010-11
8.13
7.449 Impulse 7.91
Step 7.91
7.748
7.748
2011-12
6.06 9.457 Impulse 6.09
Step 5.78
9.416
9.838
2012-13 6.67 8.078 Impulse 6.69
Step 6.40
8.051
8.445
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Monetary Policy Shock:Impact Analysis of Macro Credit Stress Testing
Note: k denotes (total) capital risk weighted asset ratio and k1 denotes tier 1 capital risk weighted asset ratio.
* Based on a more severe shock for 4 quarters at a stretch (2011Q1-Q4).
26
SCENARIOS POLICY-BASED
BaselineMonetary Policy Shock
Impulse Step
k k1 k k1 k k1
One Year Horizon
2010-11 13.4 8.38 13.1 8.11 13.1 8.11
Two Year Horizon
2011-12 11 6.32 11.1 6.36 10.7 5.94
Three Year Horizon
2012-13 10.8 6.74 10.8 6.77 10.4 6.38
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Monetary Policy Shock:Impact Analysis of Resilience of Indian Banking Sector
Results indicate the estimated total KAR (k) and Tier I KAR (k1) due to policy based shocks.
Estimated values are compared to current BASEL II norms for stability (referred to as Financial Soundness Indicators) for k & k1 to 8 % & 4 % as per international standards; and 9% & 6% as per Indian (more stringent) standards.
Overall, Indian banks meet these norms as per current BASEL II requirements.
However, if we compare the estimated values to even higher forthcoming BASEL III norms, then Indian banks are marginally constrained in meeting Tier I KAR by Indian standards.
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The external price shock (hike) causes a decline in growth rate (compared to base line scenario. The growth rate of the economy falls to 6.58% (against 6.67% for the base line scenario). Further, economy’s downturn due to this shock has an adverse impact on NPA ratio and it rises to 8.2 as compared to baseline 8.0.
Amongst all, it is the GS which is the most severe and significant in dropping GDP growth rate to 3.9 % in one year horizon and the NPA ratio rises to 12.4.
28
SCENARIOS OTHER EXTERNAL
SHOCKS
Year Baseline
(1)
External Price Shock
(3)
Global Shock
( 4) (5)**
y N y N y N y N
2010-11 8.13 7.449 8.05 7.558 7.38 8.469 7.38 8.469
2011-12 6.06 9.457 5.90 9.674 5.29 10.504 3.90 12.394
2012-13 6.67 8.078 6.58 8.200 6.74 7.983 6.86 7.819
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External Shocks:Impact Analysis of Macro Credit Stress Testing
Note: k denotes (total) capital risk weighted asset ratio and k1 denotes tier 1 capital risk weighted asset ratio.
* Based on a more severe shock for 4 quarters at a stretch (2011Q1-Q4).
29
SCENARIOS OTHER EXTERNAL SHOCKS
Baseline External Price Shock Global Shock Global Shock*
k k1 k k1 k k1 k k1
One Year Horizon
2010-11 13.4 8.38 13.3 8.28 12.4 7.44 12.4 7.44
Two Year Horizon
2011-12 11 6.32 10.8 6.1 10 5.28 8.15 3.44
Three Year Horizon
2012-1310.8 6.74 10.7 6.62 10.9 6.83 11.1 6.99
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External Shocks:Impact Analysis of Resilience of Indian Banking Sector
The results indicate the estimated total KAR (k) and Tier I KAR (k1) due to other external shocks.
These estimated values are compared to current BASEL II norms for stability (referred to as Financial Soundness Indicators) for k & k1 to 8 % & 4 % as per international standards; and 9% & 6% as per Indian (more stringent) standards.
Overall, Indian banks meet these norms as per current BASEL II requirements.
However, if we compare the estimated values to even higher forthcoming BASEL III norms, then Indian banks are marginally constrained in meeting Tier I KAR by Indian standards.
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0
2
4
6
8
10
12
14
16
18
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
NPA Ratio (%)
Figure 3 : Non-Performing Asset Ratio (%)
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10
11
12
13
14
15
16
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Bank regulatory capital to risk-weighted assets (%) - CAPITAL ADEQUACY RATIO
Figure 4 : Capital Adequacy Ratio (%)
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5
5.5
6
6.5
7
7.5
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Bank capital to assets ratio (%) -TIER 1
Figure 5 : Tier I Capital Adequacy Ratio (%)
Baseline scenario: Indian banking sector sufficiently over and above thecapital adequacy threshold according to both BASEL II & III for both leveland quality.
Significant Adverse shocks- Policy, EPS, GS: Indian banking sector largely remains SOUND in terms of total k as per current BASEL
II and even BASEL III but constrained, though not severely, as per BASEL III for Tier 1capital
Impact and thus role of monetary policy is significant Indian banks remain ROBUST with strong capital positions and sufficient
buffers during shocks as per BASEL II in three year horizon but lackedTier 1 regulatory norms and CCBs as per BASEL III
Indian banking sector is not substantially vulnerable to and hence notthreatened by various significant adverse shocks as per current BASEL.
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Overall Conclusions
Policy authorities may positively influence the leveland quality of capital adequacy to meet higherstandards of BASEL III Tier1 capital norms bypromoting growth since
impact and thus the role of monetary policy is expectedto be significant
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Policy Implications
Thank You !
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*Based on ‘‘A SMEM for India’’, Dua and Kapur(2014)
37
Alternative Scenario Maximum
POLICY SHOCK
MONETARY POLICY
(Scenario1): 𝒊 ↑
Impulse shock
Step Shock
12% for 2011Q1-Q2&
12% for 2011Q1-2013Q2
EXTERNAL SHOCK:
(Scenario5):𝐖𝐭𝐅 & 𝐖𝐭
𝐎𝐈𝐋 ↑
𝐖𝐭𝐅 187.9
𝐖𝐭𝐎𝐈𝐋 226.998 for 2011Q1-Q2
GLOBAL FINANCIAL
CRISIS(Scenario 6) : BSE ↓, FII ↓ & 𝐘𝐖 ↓
S 9177.97,
FII -138.610,
𝐘𝐭𝐖 1696436 for 2011Q1-Q2
BASELINE Same as model solution
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38
VARIABLE DEFINITION SOURCE
d1 Dummy variable equal to 1 for
2004Q2 onwards and 0 otherwise.
d2 Dummy variable equal to 1 for
2002Q1 and 0 otherwise.
e Exchange Rate (INR per US $) www.rbi.org
FII Net Foreign Institutional
Investment flows
( Rs billion)
-do-
π Annualised inflation (%) calculated
as ( 𝑷𝒕 − 𝑷𝒕−𝟏 /𝑷𝒕−𝟏 *100 using
WPI
i Nominal interest rate (%) given by
GS 10 yield rate
- do -
i1 Nominal interest rate (%) given by
TB 91 day yield rate
- do -
𝒊 Policy Rate given by Repo Rate (%)
is the rate at which the RBI lends to
commercial banks against eligible
securities in order to meet their
daily liquidity requirements.
- do -
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39
k (Total) Capital Adequacy ratio (KAR) or Capital to risk
weighted assets ratio (%) is the ratio of bank capital to
aggregate risk weighted assets(for credit risk, market risk and
operational risk).It is regarded as a measure of
soundness/internal health of an institution. The higher the k of
a bank, the better capitalized it is.
www.imf.org,IFS
K Regulatory total capital www.imf.org,IFS
K1 Tier I capital (or core capital) is a component of regulatory
capital which is considered to be of the highest quality because
they are fully available to cover losses. It mainly comprises of
share capital and disclosed reserves (minus goodwill, if any).
www.imf.org,IFS
k1 Tier I capital ratio www.imf.org,IFS
K2 Tier II capital (or supplementary capital) comprises of certain
reserves and certain types of subordinated debts.
www.imf.org,IFS
k2 Tier II capital ratio -
m Growth rate of broad money M3 (%) calculated year-on-year
basis, taken as a proxy of inflation.
N NPA Ratio (%) is the ratio of gross NPAs to gross advances.
NPA ratio (publicly available only on annual basis) on
quarterly basis is calculated by calibrating annual NPA based
on position of y-o-y non-food credit growth of the respective
quarters (with one quarter lag) with respect to March quarter*.
-
NPA Non-Performing Asset on which either the principal or the
interest is overdue for at least 90 days (Mar 2004).
www.rbi.org
Data variables, Definitions and Sources
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40
RWA Risk Weighted Assets are derived as a weighted sum
of assets where prescribed risk weights are assigned
to different types of assets according to BASEL
norms; i.e., RWA = 0%*Bucket 1 + 20%*Bucket 2 +
50%*Bucket 3 + 100%*Bucket 4; where Bucket 1, 2,
3 and 4 indicate assets with zero, low, medium and
high default risk with weights (0, 0.2, 0.5, 1) attached
to them respectively.
www.rbi.org
S BSE SENSEX www.rbi.org
WOIL
World crude oil (petroleum) index(2005=100) www.imf.org, IFS
WF
World food price index (2005=100) www.imf.org, IFS
𝐘𝐖 OECD real GDP(Rs billion) Stats.OECD
y Growth rate of real GDP (%) calculated year-on-year
basis
-
Y Real GDP at factor cost (2004-05) www.mospi.nic.in
Data variables, Definitions and Sources
20-Oct-16 Macro Stress Testing and Resilience Assessment of Indian Banking
Shock ⇨ GDP growth ↓ ⇨ (↑ in unemp an
↓ incomes) PD ↑ ⇨ Credit quality ↓ ⇨ NPAs ↑
⇨ (a) banks’ losses ↑ ⇨ banks needs to tap its
capital base to make debt payments;
(b) also provisions for NPAs ↑ ⇨ KAR ↓ ,
If < min 8% (BASEL) ⇨ banks needs to be
closed or recapitalized ⇨ contagion effects
⇨ a policy issue.
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