Asset quality forbearance to alleviate loans under crisis-induced liquidity stress adversely impacts the allocative efficiency of credit. Bank-firm-matched data from India reveal that government-owned banks increased lending to firms facing solvency pressures relative to private banks. Zombie lending crowded out productive lending, especially in industries and bank portfolios with high proportions of failing firms, controlling for demand-side factors. Reduced loan loss provisioning requirements facilitated regulatory arbitrage by banks through asset-risk reclassification, hiding true asset quality. Forbearance manifested fiscal dominance allowing the sovereign to postpone costly recapitalization— an implicit subsidy that facilitated the buildup of stressed assets in the banking system.