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 banks to delay loss recognition. Over time, these banks disproportionately curtailed lending to riskier—but potentially more productive—firms, exacerbating capital misallocation during a critical phase of India’s growth story.

Empirical Strategy

Leveraging a novel matched dataset of firm financials and bank-firm lending relationships, I use a triple-differences framework to compare outcomes for capital-constrained vs unconstrained firms, before and after the policy, across exposure to distressed banks. This allows me to isolate the causal effects of deteriorating bank health on firm behavior.

Core Findings

• Rising Misallocation and Declining Investment: Capital-constrained firms more exposed to distressed banks saw an 11% increase in their marginal product of capital (MPK), signaling inefficient allocation. These firms cut investment by 16% and reduced capital stock and expenditures by over 30%, even as their productivity declined.
• Credit Market Spillovers: Exposure to distressed banks had broader effects—external financing fell by 22%, and access to capital markets (e.g., bond and equity issuance) also weakened, suggesting systemic contagion from bank distress to the broader financial ecosystem.
• Macro-Level Losses: Industry-level estimates show cumulative productivity losses of nearly 58%, with greater misallocation, financial stress, and firm contraction in industries more exposed to weak banks. The policy weakened the resilience of India’s corporate sector for years after the GFC.

Policy Implications

The findings underscore a central tension in crisis policymaking: delaying recognition of financial stress in banks can defer—but deepen—real economy damage. While forbearance may buy time for balance sheet repair, it can also entrench weak lending practices and distort credit flows away from efficient, growth-oriented firms.

For policymakers, the lesson is clear: microprudential leniency must be complemented by macroprudential vigilance. This includes:

• Designing time-bound, conditional forbearance frameworks with credible sunset clauses.
• Enhancing transparency and asset quality monitoring during crisis interventions.
• Supporting firm access to alternative financing channels (e.g., capital markets, development finance) to reduce overreliance on distressed banks.

Ultimately, preserving allocative efficiency during periods of financial stress is essential for sustaining long-run growth. Capital misallocation, once embedded, is hard to reverse—highlighting the importance of aligning financial sector policy with broader economic resilience goals.

Read the full paper here