The global decline in productivity growth over the past two decades is a pressing challenge, with capital misallocation identified as a significant contributor. This phenomenon is particularly acute in emerging economies where banks play a central role in capital allocation. Despite this, the connection between financial stability policies and capital misallocation remains underexplored. India’s regulatory forbearance policy (2008-2015) provides a unique context to investigate this problem, as the policy exacerbated banking stress, disrupted credit markets, and led to significant declines in capital formation and investment in India. Understanding these dynamics is crucial for policymakers aiming to balance short-term financial stability with long-term economic efficiency​.

This paper examines how India’s regulatory forbearance policy aggravated firm-level capital misallocation and impacted productivity and investment. By combining firm-level data with bank-firm lending relationships, the paper explores the effects of exposure to distressed banks on capital allocation, investment, and productivity. Using a triple-differences framework, it quantifies the economic costs of this policy, shedding light on how regulatory interventions can propagate inefficiencies in resource allocation through the banking sector​.

The findings reveal substantial productivity and investment losses linked to the forbearance policy. Average annual industry productivity losses are estimated at 12.4%, with cumulative losses reaching 57.6%. Capital-constrained firms exposed to distressed banks faced increased financing constraints, leading to an 11% rise in marginal product of capital, a 16% drop in investment, and a 22% reduction in external financing. The misallocation of resources was more pronounced in industries heavily reliant on struggling banks, highlighting the macroeconomic ramifications of bank distress

This paper extends the literature by highlighting the critical role of banks in capital misallocation, particularly in the context of regulatory forbearance. It provides empirical evidence that deteriorating bank health not only directly constrains firms but also amplifies broader economic inefficiencies. The results underscore the need for cautious implementation of financial stability policies, ensuring they do not undermine long-term productivity and economic growth​.

By leveraging a unique policy experiment in India, this paper bridges gaps in the literature on capital misallocation, financial frictions, and regulatory interventions. It offers a robust framework for analyzing the unintended consequences of financial policies on resource allocation. For policymakers, the study provides actionable insights into the trade-offs between immediate financial stability and sustained economic efficiency, emphasizing the importance of monitoring and mitigating the downstream effects of such policies.

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