We test a bank credit channel through which unexpected increases in inflation lead to short-run macroeconomic fluctuations. For identification, we study an unexpected U.S. inflation increase in early 1977 and exploit differences in state-level reserve requirements for Federal Reserve nonmember banks, which create differences in banks’ inflation exposures. More exposed banks reduce lending, lowering local house prices and construction employment. We provide evidence for potential mechanisms, including a bank net wealth and a loan misallocation channel. Our results suggest that an important consequence of inflation is its impairment of the banking sector.

Supervisory assessments such as stress-tests gauge banks’ riskiness and allow regulators to impose bank-specific capital regulation. This can improve welfare. Yet, regulation based on noisy supervision can decrease welfare by mis-classifying banks, distorting incentives, and crucially, leading to greater risk taking. Regulation should not be bank-specific in such cases. When bank defaults are costlier, supervision should strive for lower probability that riskier banks go undetected, i.e., reduce false-negatives even if this causes more false-positives. When the supervisor can incur a cost to optimally reduce both false-positive and false-negative rates, the regulator should make capital requirements more bank specific.