The Unintended Consequences Of Regulatory Forbearance
Author(s) Anusha Chari, Lakshita Jain and Nirupama Kulkarni


The Reserve Bank of India enacted a series of ‘asset-quality’ forbearance measures during the global financial crisis. Using a bank-firm matched dataset, we find that there is a strong positive correlation between bank- and firm-distress measures and evidence suggests that the forbearance measures encouraged stressed banks to channel credit to low-liquidity and low-solvency firms. Lending to zombie-firms increases and to healthy firms falls significantly for industries and banks with higher proportions of zombies. The data show that prolonged periods of forbearance on bank lending can have persistent effects on the structure of bank-firm relationships. Stressed banks end up in sticky matches with low-quality borrowers and healthy borrowers are more likely to migrate to private banks, foreign banks and non-banking companies in search. Overall, our results suggest that forbearance provided banks with an incentive to hide true asset quality and a license to engage in regulatory arbitrage. Thus, the build-up of stressed assets in the banking system is a by-product of accounting subterfuge.

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