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detailed Asset Quality Review (AQR) to know the true status of banks’ NPAs. However, as Chopra,
Subramanian, and Tantri (2020) document, the AQR exacerbated the problem as it neither mandated
capital raising by banks nor provided a capital backstop even though it was certain that banks’
capital would be adversely impacted following the AQR.

7.30 Economic theory highlights that two contrasting outcomes were possible with such an AQR.
In the optimistic view, the AQR was expected to lead to a reduction in information asymmetry.
The critical assumption – as hypothesized in Diamond and Rajan, 2011– was that the resultant
cleaner bank balance sheets would help banks to raise more private capital on their own, thereby
improving the quality of financial intermediation. Along these lines, the RBI’s view was that the
program was a “deep surgery” that would lead to healthy bank balance sheets (Rajan, 2016).

7.31 However, a more sobering outcome could have been expected from an application of the
impact of asymmetric information problems on the likelihood of capital raising. Myers and
Majluf (1984) predict that firms in distress would have no incentive to raise equity voluntarily
as managers – who know more about the firm’s fundamentals than investors – fear dilution of
the value of equity. Therefore, absent a policy for either mandatory capital raising or capital
backstop, incumbent shareholders and managers of banks – who would invariably know more
about the bank’s fundamentals than the regulator or investors – have no incentive to raise equity
capital. Implicit government guarantees further dis-incentivize capital raising (Admati and
Hellwig, 2014). As a result, under-capitalized banks may again resort to risk-shifting and zombie
lending, thereby severely exacerbating the problem. The adverse impact could then spill over to
the real economy through good borrowers and projects being denied credit. The resultant drop
in the investment rate of the economy could then lead to the slowdown of economic growth.
Chopra, Subramanian, and Tantri (2020) provide careful evidence that this is precisely what
transpired following the AQR.

The crucial difference vis-à-vis bank clean-ups in the rest of the world
7.32 In this context, it is crucial to understand that India’s AQR differed from the typical bank
clean-ups carried out in other major economies such as Japan, the European Union, and the U.S.
in two key aspects. First, the clean-up was undertaken when the country was not undergoing
an economic crisis. Given the economic stability, RBI assumed that markets would supply the
required capital to banks once their books are cleaner, as explained in Section 8.30. Second,
there was neither a forced recapitalization of the banks nor was an explicit capital backstop
provided for. RBI initiated the AQR under the presumption that the extent of additional loan
provisioning required due to the clean-up would not generate needs for a severe recapitalization
of the banks. 4

4 For instance, Rajan (2016) states: “The Government has been fully involved and supportive. We have
mapped out a variety of scenarios on possible outcomes. The Finance Minister has indicated he will
support the public sector banks with capital infusions as needed. Our estimate is that the government
support that has been indicated will suffice… Our projections are that any breach of minimum core cap-
ital requirements by a small minority of public sector banks, in the absence of any recapitalization, will
be small… What the Government has already explicitly committed is, in our view, enough to take care
of all reasonable scenarios, and the Government has committed to stand behind its banks to whatever
extent needed.” The RBI envisaged the program as temporary and the banking sector “to have a clean
and fully provisioned balance sheet by March 2017… In sum, while the profitability of some banks may
be impaired in the short run, the system, once cleaned, will be able to support economic growth in a
sustainable and profitable way.” For private sector banks, RBI expected that “Our various scenarios also
show private sector banks will not want for regulatory capital as a result of this exercise.”