Financial theory suggests that leverage causes firms to underinvest and that the extent of underinvestment is related to the degree of financial leverage. This prediction is consistent with both time series and cross-sectional patterns in bank lending. Bank capital typically declines in recessions due to loan losses, and this effectively increases financial leverage. As a result, system-wide underinvestment by banks is a contributing factor in “credit crunches.” In the cross section, banks with relatively poor loan quality, capital, and/or liquidity and weak banks with more opportunities subject to underinvestment should and do experience lower loan growth. Cross-sectional differences in the use of subordinated debt and in the extent of securitization provide additional evidence in support of the underinvestment hypothesis.Journal of Economic LiteratureClassification Numbers: E51, G21.