When Losses Turn Into Loans: The Cost of Undercapitalized Banks

When Losses Turn Into Loans: The Cost of Undercapitalized Banks

By Laura Blattner, Luísa Farinha, Francisco Rebelo
June 26,2018Working Paper No. 3688

Winner 2017 BlackRock Applied Research Award

AQR Top Finance Graduate Award 2018

We provide evidence that a weak banking sector contributed to low productivity following the European debt crisis. An unexpected increase in capital requirements provides a natural experiment to study the effects of reduced capital adequacy on productivity. Affected banks respond by cutting lending but also by reallocating credit to distressed firms with underreported loan losses. We develop a method to detect underreported losses using loan-level data. We show that the credit reallocation leads to a reallocation of production factors across firms. We find that the resulting factor misallocation accounts for 20% of the decline in productivity in Portugal in 2012.