Banking Reform, Credit Allocation, and Local Real Effects: Evidence from India

We leverage the Reserve Bank of India’s 2006 Bank Authorization Policy as a quasi-natural experiment to study effects on credit markets, capital misallocation, and firm outcomes. We find asymmetric responses: private-sector bank branches expanded by 16.3% in underbanked districts relative to banked districts, while public-sector banks showed no systematic expansion. The resulting private-sector lending reduced the marginal revenue product of capital (MRPK) of ex-ante high-MRPK firms by about 60%, lowering capital misallocation. However, this decline did not raise firm sales or value added. We highlight the efficacy of financial reforms in alleviating misallocation under mixed-ownership banking environments in developing economies.