Misallocated Capital, Cascading Consequences: From bank health to firm investment in the shadow of forbearance

This paper investigates how financial sector policies—specifically regulatory forbearance for banks—can generate unintended and persistent distortions in capital allocation, with significant macroeconomic consequences. Using the case of India’s 2008–2015 forbearance policy, I show how masking bad loans on bank balance sheets worsened credit frictions for already-constrained firms, leading to widespread capital misallocation, declining investment, and productivity losses. Motivation and Context In response to the Global Financial Crisis, India implemented a forbearance regime allowing banks to restructure loans without classifying them as non-performing. While intended as a precautionary buffer for financial stability, this policy inadvertently reduced credit discipline and allowed weak...