What Does Matched Bank-Firm Data Tell Us about the Moral Hazard in Lending Decisions of State-Owned Banks in India? (Revised as on January 3, 2018)

In this study, we examine quality of the lending decisions of public sector banks (PSBs) in India with a novel dataset which allows the identification of both the banks by the ownership types and their borrowers. We use a lender type prediction model where the bank type is determined by observable risk proxies such as ex-ante credit ratings, which influence the lending decision. The analysis of the lending decisions indicate that the PSBs are more likely to lend to observably less creditworthy firms relative to the private banks (PBs). We also find that smaller firms have a higher likelihood of obtaining credit exclusively from PSBs, possibly, consistent with the directed lending programs of the government. If we exclude systemically important banks and their borrowers from the sample, the likelihood of riskier firms obtaining credit exclusively from PSBs increases. Finally, firms which are likely to be impacted by political regime changes have a higher likelihood of an exclusive borrowing relationship with PSBs. The study contributes to the contemporary debates on the role of market discipline, disclosures, and moral hazard in banking.