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.