‘By a silken thread’: Regional banking integration and credit reallocation during Japan's lost decade

Regional banking integration allows credit to be reallocated to regions with high credit demand. Using the natural experiment of Japan's lost decade, we show that this reallocation channel mitigated the real effects from the bank liquidity shock in prefectures with many bank-dependent small firms. We propose an instrument for modern-day regional banking integration that exploits the fact that regional segmentation of banking markets in Japan goes back to the institutions set up for silk export finance in the late 19th century. We illustrate how the difference between the OLS and IV estimates can provide information about unobserved cross-regional heterogeneity in bank-firm matches when only aggregate regional data is available. Our results highlight that well-integrated banking markets are important and complementary to bond markets in limiting macroeconomic asymmetries in a monetary union, in particular during major financial crises.