Could Expansions in Directed Lending Programs Hurt Small Businesses? Evidence from a Policy Change in India

Abstract

I study the impact of the expansion in a national-level directed lending program aimed at increasing institutional credit access of small firms in India. In 2006, the Government of India changed the criterion determining the small status of firms, thereby expanding the pool of small firms eligible for directed credit. Exploiting this expansion in the pool of firms eligible for directed lending, I analyze the crowding out of the previously eligible firms by the recently eligible firms. I find that the recently eligible firms disproportionately grew their bank credit stock relative to previously eligible firms, without substituting other forms of credit for bank loans. The recently eligible firms also experience a jump in investment and sales growth post the policy change, while there is no evidence of a similar improvement in the real outcomes for the previously eligible small firms. The study brings to light the unintended effects of policy expansions, resulting in hurting the smaller, more financially vulnerable firms, by distorting the lending incentives of institutional lenders.