There is anecdotal evidence that banks in India have been financing distressed firms to delay the recognition of bad loans. Extending credit to firms that face temporary financial stress may be critical for keeping them operational and reviving them. However, lending to firms that are highly distressed and have little or no ability to repay these loans is tantamount to throwing good money after bad. This reduces the supply of bank credit to healthy, more productive firms; hides the true extent of balance sheet impairment; and delays resolution of firms’ distress. Such delays may increase the eventual losses faced by banks. We find preliminary evidence that banks have indeed been lending to highly distressed firms, a large fraction of which may have been economically unviable.
Unlike developed countries, corporate distress in India is not identifiable from market mechanisms. To identify distress, we look at firms that were referred to the Corporate Debt Restructuring (CDR) mechanism. Initiated in 2001 by the Reserve Bank of India (RBI), the CDR scheme was aimed at alleviating distress in economically viable firms, and through this, control the rising non-performing assets (NPA) on banks’ balance sheets. In the wake of the 2008 global financial crisis, the RBI provided regulatory forbearance to the scheme, permitting banks to hold lower provisions against loans given to CDR firms. Using a sample of 114 firms referred to the CDR forum during 2008-2012, we analyse the financial health of firms and the evolution of their bank-borrowing patterns before and after they received CDR.