Sovereign debt exposure and the bank lending channel: impact on credit supply and the real economy

We examine the transmission of a bank balance sheet shock to corporate credit and its effects on investments and employment. Using detailed loan level data matching firms and banks in Italy, we show that the exogenous shock to sovereign securities held by financial intermediaries, which was triggered by the Greek bailout (2010), was passed on to firms through a contraction of credit supply. The contraction of credit supply was similar in size for both large and small firms. However, it led to a reduction in investment and employment only for the smaller firms, especially those which rely heavily on external financing. These effects were further exacerbated by the geographical segmentation of the credit market. Investigating the heterogeneity of the bank lending channel across financial intermediaries, we found a sharper tightening of credit supply among banks closer to the regulatory capital constraint. We conclude that the interaction of banks’ and firms’ balance sheet is crucial for understanding the transmission of credit supply shocks to the real economy.