Government Subsidies, Credit Allocation and the Investment Cycle

We present a model of banking with adverse selection and public guarantees extended to state-owned lenders. We find that while these guarantees induce the banking sector to lend to a larger proportion of firms with positive value, this occurs as a result of a reduction in prudential incentives to screen borrowers by state-owned banks which results in credit supply at a less than actuarially fair price. When the subsidy is tied to evergreening of non-performing loans as opposed to recapitalization post prompt loss recognition, it generates excessive credit allocation to low-productivity, legacy projects at the expense of higher-productivity firms. In the aggregate, this decreases investment, productivity growth and output while increasing financial stability risk. We apply our theoretical predictions to explain the coincidence of rising bank vulnerability and the investment slowdown in India over the last decade.