Preventing Defaults in Response to Deteriorating Bank Health: The Prompt Corrective Action Approach

ABSTRACT Prior research shows that borrowers are more likely to default when their banks are financially distressed, particularly where contract enforcement is weak. We examine whether regulatory intervention in the form of Prompt Corrective Action (PCA), which seeks to improve bank health through enhanced monitoring, reverses such defaults. To address this question, we exploit the bright‐line entry thresholds in India's PCA regime using a regression discontinuity framework. We first show that such defaults exist in India. Our main result is that PCA intervention significantly reduces such defaults. The result is robust to variation in methodology and alternative definitions of bank health. Our evidence suggests that PCA reduces such defaults by credibly signaling to borrowers the likely restoration of bank health and continuity of lending relationships. Its effectiveness was reinforced by an earlier regulatory reform that improved the timeliness of loan‐loss provisioning, enhancing the credibility of enforcement. Overall, our findings suggest that PCA, when underpinned by credible financial reporting, can serve as an effective policy tool to curb strategic defaults.