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H IDDEN DEBT
First, firms that move from banking with a private bank to banking with a SOCB invest less on average—controlling for firm characteristics and past investments (table 2B.7, column 2). Even when switching to SOCBs, firms with higher growth of sales invest more than other firms that switch to SOCBs. However, firms with high growth of sales still invest less when switching to SOCBs rather than when banking with private banks. Second, the big story emerges in the relation of SMEs to SOCBs. When we control for SMEs,16 the results show a stark contrast between SMEs and larger firms. Namely, larger firms that switch to banking with SOCBs invest more on average; this suggests that the earlier negative estimate was driven by SMEs. Larger firms with higher growth of sales invest more than other larger firms that switch to SOCBs—even more so than average firms that switch to a private bank (0.0342 +
0.0124 = 0.0466). However, SMEs that switch to SOCBs invest significantly less than other firms (table 2B.7, column 4). The estimate is economically more significant than the effect of size, age, or sales growth. Moreover, successful SMEs with high sales growth are held back even more by switching to SOCBs in trying to realize their investment potential (see column 5 of table 2B.7, the triple interaction with PSB × Sales growth × SME). This could suggest that SOCBs are particularly challenged by screening SME creditworthiness and potential for investment. Future research could focus on whether this result could be due to SOCBs not lending enough to SMEs overall or the willingness of SOCBs to lend to SMEs only for working capital needs, on average. The result reflects the anecdotal evidence about SOCB lending practices and credit underwriting. Anecdotal evidence suggests that SOCBs focus more on meeting the lending quotas for
BOX 2.1 Main Findings of the Overall Analysis State-owned banks, smaller banks, and banks with a higher intermediation ratio of loans to deposits—but still less than 100 percent—are more prone to distress. The higher average vulnerability of state-owned commercial banks (SOCBs) to distress may increase with the share of state ownership, or at least it does in India. SOCBs adjust in distress differently than private banks because of their soft budget constraints. Weaker SOCBs enter distress more often than private banks, and when distressed, they reduce lending more than healthy state banks. Although private banks enter distress less frequently, when they do, they reduce lending much more than state banks in distress—and therefore, much more than healthy SOCBs. In terms of financing, SOCBs enjoy softer budget constraints, readily obtaining state equity and debt support. The softer budget constraints, as well as conditions of government recapitalization, enable SOCBs to sustain lending to clients and their own investments in times of distress.
However, the soft budget constraints impose substantial fiscal costs and erode market discipline. This raises the question of whether this costly insurance and risk-absorbing function of SOCBs pays off in terms of wider economic benefits, such as sustained firm investment. The type of bank ownership (public versus private) affects the investment of client firms, with important effects on the economy. Namely, larger firms that switch to banking with SOCBs as opposed to banking mainly with private banks invest more than other firms. This is especially true for larger firms with a higher growth of sales. The opposite is true for SMEs. SMEs that switch to SOCBs invest significantly less than other firms—especially successful SMEs with high sales growth. This finding may be explained in part by the weak risk management culture at state commercial banks—including their low capability to appraise SMEs’ creditworthiness and screen individual SME investment projects for viability (Mishra, Prabhala, and Rajan 2019).
