The Real Effects of Bank Supervision: Evidence from On-Site Bank Inspections

We show that bank supervision reduces distortions in credit markets and generates positive spillovers for the real economy. Combining a novel administrative dataset of unexpected bank inspections with a quasi-random selection of inspected banks in Italy, we show that inspected banks are more likely to reclassify loans as non performing after an audit. This behavior suggests that banks are inclined to misreport loan losses and evergreen credit to underperforming firms unless audited. We find that this reclassification of loans leads to a temporary contraction in lending by audited banks. However, this effect is completely driven by a credit cut to underperforming firms, as the composition of new lending shifts toward more productive firms. As a result, these productive firms increase employment and invest more in fixed capital. We provide evidence of a mechanisms for our results: a change in bank governance. Finally, we find positive spillovers from inspections: entrepreneurship increases, underperforming firms are more likely to exit the market, and there is an overall increase in productivity in the local economy as a result. Taken together, our results show that bank supervision is an important complement to regulation in improving credit allocation.