Medicine Or An Addictive Drug? : The Vicious Cycle Of Regulatory Forbearance

At the onset of the financial crisis, the Indian regulator allowed banks to restructure loans without downgrading and providing for them. The special treatment to the infrastructure sector, plausibly driven by the political economy, and heterogeneity in bank exposure provide identification. Even after the crisis dissipated, banks remained undercapitalized and the regulator continued forbearance. The bank shareholders enhanced their put option by increasing dividend payments. Lending distortions due to undercapitalization and a banking crisis followed. Forbearance created a vicious cycle where forbearance in response to exogenous shocks made otherwise healthy banksundercapitalized leading to its extension even after economic recovery