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When Losses Turn Into Loans: The Cost of Undercapitalized Banks

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  • Laura Blattner
  • Luisa Farinha
  • Francisca Rebelo

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.

Suggested Citation

  • Laura Blattner & Luisa Farinha & Francisca Rebelo, 2017. "When Losses Turn Into Loans: The Cost of Undercapitalized Banks," 2017 Papers pbl215, Job Market Papers.
  • Handle: RePEc:jmp:jm2017:pbl215
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    More about this item

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation
    • E51 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Money Supply; Credit; Money Multipliers
    • D24 - Microeconomics - - Production and Organizations - - - Production; Cost; Capital; Capital, Total Factor, and Multifactor Productivity; Capacity
    • O47 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - Empirical Studies of Economic Growth; Aggregate Productivity; Cross-Country Output Convergence

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