Lending Standards Over the Credit Cycle

We analyze howfirms' segmentation into credit classes affects the lending standards applied by banks to small and medium enterprises over the cycle. We exploit an institutional feature of the Italian credit market that generates a discontinuity in the allocation of comparable firms into the performing and substandard classes of credit risk. In the boom period, segmentation results in a positive interest rate spread between substandard and performing firms. In the bust period, the increase in banks' cost of wholesale funds implies that substandard firms are excluded from credit. These firms then report lower values of production and capital investments.