When Losses Turn Into Loans: The Cost of Undercapitalized Banks

Laura Blattner, Luisa Farinha and Francisca Rebelo

2017 Papers from Job Market Papers

Abstract: We provide evidence that a weak banking sector has contributed to low productivity growth in the aftermath of the European sovereign debt crisis. An unexpected increase in capital requirements for a subset of Portuguese banks in 2011 provides a natural experiment to study the effects of reduced bank capital adequacy on productivity. Using detailed administrative data from the Bank of Portugal, we show that affected banks respond not only by cutting back on lending but also by increasing their underreporting of loan losses, which inflates reported capital, and by reallocating credit to firms in financial distress with prior underreported losses. To establish these results, we develop a method to detect the underreporting of losses using detailed loan-level data. We argue that this credit reallocation is consistent with distorted lending incentives arising either from the attempt to avoid the recognition of underreported losses, or from gambling on risky firms in response to an expected government bailout. We then show that the credit reallocation affects firm-level investment and employment. Finally, we translate the firm-level changes into aggregate productivity. This partial equilibrium exercise suggests that the credit reallocation driven by the regulatory intervention accounts for 20% of the decline in productivity in Portugal in 2012.

JEL-codes: D24 E51 G21 G38 O47 (search for similar items in EconPapers)
Date: 2017-12-04
New Economics Papers: this item is included in nep-ban, nep-eec and nep-eff
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (11)

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Related works:
Working Paper: When losses turn into loans: the cost of undercapitalized banks (2019)
Working Paper: When Losses Turn into Loans: The Cost of Undercapitalized Banks (2018)
Working Paper: When losses turn into loans: the cost of undercapitalized banks (2018)
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