This paper provides evidence on the strategic lending decisions made by banks facing a negative funding shock. Using bank–firm level credit data, we show that banks reallocate credit within their loan portfolio in at least three different ways. First, banks reallocate to sectors where they have a high market share. Second, they also reallocate to sectors in which they are more specialized. Third, they reallocate credit toward low-risk firms. These reallocation effects are economically large. A standard deviation increase in sector market share, sector specialization, or firm soundness reduces the transmission of the funding shock to credit supply by 22%, 8%, and 10%, respectively.

Theory offers conflicting predictions on how bank specialization affects corporate innovation. We show that the sign and magnitude of this effect vary with the degree of “asset overhang” across sectors—the risk that new technologies reduce the value of banks’ legacy loan portfolios. Using Belgian innovation survey data and US patent data, we find that lenders’ sectoral specialization enhances innovation for firms operating in sectors with low asset overhang, but hinders innovation in sectors with high asset overhang. These findings are robust to different measures of asset overhang and an identification strategy using bank mergers. We further show that these heterogeneous effects arise through financial contracting. Our findings highlight how product market characteristics shape the role of bank specialization in innovation.