Schumpeterian Banks: Credit Reallocation and Capital Requirements

Capital reallocation from unprofitable to profitable firms is a key source of productivity gain in an innovative economy. We present a model of credit reallocation and focus on the role of banks: Weakly capitalized banks hesitate to write off non-performing loans to avoid a violation of regulatory requirements or even insolvency. Such behavior blocks credit to expanding industries and results in insufficient credit reallocation across sectors and a distorted capital allocation. Reducing the cost of bank equity, tightening capital requirements, and improving insolvency laws relaxes constraints and mitigates distortions.