The Unholy Trinity: Regulatory Forbearance, Stressed Banks and Zombie Firms
During the global financial crisis, the Reserve Bank of India enacted forbearance measures that lowered capital provisioning rates for loans under temporary liquidity stress. Matched bank-firm data reveal that troubled banks took advantage of the policy to also shield firms facing serious solvency issues. Perversely, in industries and bank portfolios with high proportions of failing firms, credit to healthy firms declined and was reallocated to the weakest firms. By incentivizing banks to hide true asset quality, the forbearance policy provided a license for regulatory arbitrage. The build-up of stressed assets in India’s predominantly state-owned banking system is consistent with accounting subterfuge.
We thank workshop participants at Columbia University, UNC-Chapel Hill, the Reserve Bank of India, the IIM Calcutta-NYU Stern India Conference, Norges Bank, and the FDIC for helpful comments and suggestions. We thank Viral Acharya, Arvind Panagariya, Jagdish Bhagwati, Pravin Krishna, Suresh Sundaresan, Manju Puri, the late Subir Gokarn, Yasser Boualam, Rakesh Mohan, and Krishnamurthy Subrahmanian for helpful discussions. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.