We provide evidence that a weak banking sector has contributed to low productivity growth following 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 eects of reduced bank capital adequacy on productivity. Aected banks respond not only by cutting back on lending but also by reallocating credit to rms in nancial distress with prior underreported loan loss provisioning. We develop a method to detect when banks delay loss reporting using detailed loan-level data. We then show that the credit reallocation leads to a reallocation of production factors across rms. A partial equilibrium exercise suggests that the resulting increase in factor misallocation accounts for 20% of the decline in productivity in Portugal in 2012.

We provide evidence that banks distort the composition of credit supply in order to comply with ratio-based capital requirements in times of economic distress. An unexpected intervention by the European Banking Authority provides a natural experiment to study how banks respond to falling below minimum required capital ratios during an economic downturn. We show that 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. The credit reallocation leads to a reallocation of inputs across firms. We calculate that the resulting increase in input misallocation accounts for about 22 percent of the decline in productivity in Portugal in 2012. (JEL E23, E32, G21, G28, G32, G38)