Financial Misconduct, Fear of Prosecution and Bank Lending

The issue and relevance of financial misconduct and fear of prosecution on the lending behaviour of Indian banks is investigated by combining bank-level financial and prudential variables during 2008–18 with a unique hand-collected data set on financial misconduct and fear of prosecution. The findings indicate that, in the presence of financial misconduct, state-owned banks typically cut back on credit creation and instead increase their quantum of risk-free investment. In terms of magnitude, a 10% increase in financial misconduct lowers lending by 0.2% along with a roughly commensurate increase in investment. In terms of the channels, it is found that private banks increase provisioning to maintain their credit growth, although the evidence for state-owned banks is less persuasive.

The authors would like to thank, without implicating, the anonymous referee for the extremely useful comments and insights on an earlier draft, which greatly improved the exposition and analysis. The views expressed and the approach pursued in the paper is that of the authors.