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

Abstract

At the onset of the financial crisis, the Indian regulator allowed banks to restructure loans without downgrading and providing for them. Banks tunneled capital by increasing dividends from profits engineered using regulatory forbearance. Even after the crisis dissipated, banks remained undercapitalized, forcing the regulator to continue forbearance. Lending distortions due to undercapitalization and a banking crisis followed. The ruling elite benefited by obtaining more restructuring for firms in influential districts, increased dividends on the government's shareholding, and taxes. Thus, regulatory forbearance created a vicious cycle where exogenous shocks made otherwise healthy banks undercapitalized leading to its extension even after economic recovery.