DP11901 | Credit Misallocation During the European Financial Crisis

Publication Date

03/10/2017

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Abstract

Do banks with low capital extend excessive credit to weak firms, and does this matter for aggregate efficiency? Using a unique data set that covers almost all bank-firm relationships in Italy in the period 2008-2013, we find that, during the Eurozone financial crisis: (i) Under-capitalized banks cut credit to healthy firms(but not to zombie firms) and are more likely to prolong a credit relationship with a zombie firm, compared to stronger banks. (ii) In areas-sectors with more low-capital banks, zombie firms are more likely to survive and non-zombies are more likely to go bankrupt; (iii) Nevertheless, bank under-capitalization does not hurt the growth rate of healthy firms, while it allows zombie firms to grow faster. This goes against previous influential findings that, we argue, face a serious identification problem. Thus, while banks with low capital can be an important source of aggregate inefficiency in the long run, their contribution to the severity of the great recession via capital misallocation was modest.