Financial Wiring, Not Just Weak Banks, Drives Systemic Risk in India
Systemic risk in India’s financial network is amplified less by market shocks than by how institutions are connected
Harshit Kumar Sharma: IIT Kanpur
Wasim Ahmad: IIT Kanpur
SDG 8: Decent Work and Economic Growth | SDG 9: Industry, Innovation and Infrastructure
Reserve Bank of India | Ministry of Finance
India’s financial system is best seen as a tightly wired network – banks, NBFCs, markets and policy institutions linked through funding, exposures and expectations. In calm times, this wiring supports credit flow and stability. Under stress, it can turn modest shocks into economy-wide events.
Yet India’s regulatory and supervisory toolkit largely treats institutions in isolation – as if balance sheets rather than connections were the primary source of systemic risk. That gap between how the system is governed and how it actually behaves increasingly explains why financial stress in India often escalates quickly, even when the initial trigger appears contained.
How Shocks Travel Through India’s Financial Network
Evidence from Indian financial data since the mid-2000s shows a system that is persistently interconnected, but unevenly so. Even outside crisis periods, total connectedness in the Indian financial network typically remains high, rarely falling below roughly three-quarters of its maximum value. Total connectedness here refers to the degree to which shocks to one financial institution’s balance sheet transmit to others over time. During episodes of stress, such as the Global Financial Crisis, the European sovereign debt crisis, the 2013 taper tantrum, the IL&FS collapse, and the COVID-19 shock, connectedness rose sharply, often exceeding 90 percent of its maximum value.
In practical terms, balance sheets begin to move in sync. Distress in one corner travels faster and further, converting what might have remained a sectoral problem into a system-wide one. This is not an episodic anomaly but a recurring pattern across crises.
Within this network, large public and private banks, such as SBI, ICICI Bank and PNB, emerge consistently as net emitters of shocks. Net emitters are institutions whose stress is more likely to travel outward to others. Smaller private banks and large NBFCs are more often net receivers, reflecting their dependence on bank funding and wholesale markets.
Crucially, this hierarchy is not fixed. During the IL&FS episode, liquidity stress originating in parts of the NBFC sector flipped the direction of contagion – the process by which funding and valuation shocks at one institution spread to others – with many NBFCs temporarily becoming net spreaders of risk. This episode shows that contagion in India does not flow in a single, predictable direction. Under acute liquidity stress and funding constraints, institutions that are usually shock absorbers can become sources of instability.
Contagion Dynamics and Systemic Risk
The Network Volatility Index (NetVIX) – a network-based indicator that combines market volatility with how strongly institutions transmit shocks to one another – offers a clearer lens on systemic risk in India. It reached its highest recorded level during the COVID-19 shock, signalling unprecedented system-wide stress .
Its decomposition is revealing. Systemic risk in India is driven overwhelmingly by the network contagion component rather than by conventional market volatility. The volatility component remains close to zero even during major stress episodes, while the contagion component stays persistently elevated.
What makes crises dangerous in India is not how large the initial shock is, but how tightly financial institutions are coupled when it arrives.
This distinction helps explain why episodes with very different triggers can generate similar systemic stress. During the 2013 taper tantrum, for instance, external volatility was limited and short-lived, yet funding pressures spread rapidly across banks and NBFCs once domestic financial linkages tightened, amplifying the initial shock beyond its external origin.
Asymmetric Feedback Between Risk and Interconnectedness
Interconnectedness and systemic risk reinforce each other, but asymmetrically.
A sudden rise in systemic risk, measured by NetVIX, leads to an immediate tightening of financial linkages across the network. This effect peaks within the first two months and remains significant for nearly four months. In contrast, a shock to connectedness dissipates within roughly two months.
Stress, once amplified through the network, can harden contagion for several months even after the original trigger weakens. India’s vulnerability, therefore, lies less in predicting the next global disturbance and more in recognising when domestic financial linkages have become sufficiently tight that even moderate shocks – through interest rates, capital flows or exchange rates – can be magnified into systemic events.
Institutions as Hubs, Not Just Balance Sheets
The same feedback operates at the level of individual institutions; shifting the focus from the system as a whole to the position of specific entities within it. When an institution’s contribution to systemic risk rises, its net connectedness within the financial network increases immediately and remains elevated for an extended period. The effect builds gradually, peaks around the eighth month, and stays statistically significant for up to a year.
Systemic importance, therefore, reflects not only size or leverage, but an institution’s evolving role as a hub within the financial network.
When the direction is reversed – a sudden increase in an institution’s net connectedness – it leads to an immediate rise in its systemic risk contribution, persists in the short run, and gradually fades over time.
Regulation and Design Shape the Network
The structure of systemic risk is shaped by regulation and institutional design in India.
India’s financial architecture combines large public-sector banks with strong sovereign links, major private banks reliant on market funding, and NBFCs dependent on short-term wholesale borrowing. Together, they form dense funding and credit chains. When policy choices alter incentives – through recapitalisation announcements, regulatory forbearance or liquidity support – they also reshape the network: who becomes central, who depends on whom, and how easily stress propagates.
This is evident in the data. One of the sharpest increases in total connectedness outside the pandemic followed the October 2017 announcement of a ₹2.11-lakh-crore public-sector bank recapitalisation programme. The episode is instructive because it was not triggered by market panic, but by a policy intervention aimed at restoring balance-sheet strength.
By signalling sovereign backing and accelerating balance-sheet repair across public-sector banks, the announcement tightened financial linkages rather than loosening them, increasing the system’s overall coupling even in the absence of an external shock.
External shocks may arrive through global financial channels, but they become domestic systemic events because of how Indian institutions are connected to one another. Policy actions, no less than crises, can therefore alter the network’s topology in ways that affect how future stress is transmitted.
This points to a “robust-yet-fragile” Indian financial system: one that absorbs small shocks in tranquil times, but amplifies stress sharply once key thresholds are crossed.
Political Economy and Accountability
A network perspective raises institutional and communication challenges, and it makes them unavoidable. Deepening financial markets and expanding credit intermediation have been deliberate policy choices. Recognising the risks embedded in financial linkages does not negate those objectives, it clarifies the conditions under which they remain sustainable.
The task ahead is institutional rather than technical: building the capacity to see risk where it accumulates, to act before contagion hardens into crisis, and to communicate interventions in a system whose stability now depends as much on its connections as on its capital.
The question, therefore, is no longer whether shocks will occur, but whether India’s financial network is designed to absorb them or to propagate them.
Authors:
The discussion in this article is based on the authors’ research published in the Emerging Markets Review (Volume 69). Views are personal.