Does Debt Overhang Impound Market Discipline: A Study of Bank Risk-taking Using a Natural Experiment

Starting 2015, the Indian banking regulator conducted clean-up exercise of banks’ balance sheets—aka asset quality review (AQR). This clean-up drive came along with a divergence disclosure, which captures the deviation in asset quality between the regulator and the bank’s assessment. We exploit this natural experiment to tease out the causal impact of divergence disclosure on risk-taking behavior in the presence of two counter-appealing theories: “market discipline” and “debt overhang.” Our results show that divergence disclosures do not discipline banks but rather amplify risk-taking behavior. JEL Codes: G21, E58, G32