Small Firms and Domestic Bank Dependence in Europe’s Great Recession

Small businesses (SMEs) depend on banks for credit. We show that the severity of the
Eurozone crisis was worse in countries where firms borrowed more from domestic banks
(“domestic bank dependence”) than in countries where firms borrowed more from
international banks. Eurozone banking integration in the years 2000–2008 mainly
involved cross-border lending between banks while foreign banks’ lending to the real
sector stayed flat. Hence, SMEs remained dependent on domestic banks and were
vulnerable to global banking shocks. We confirm, using a calibrated quantitative model,
that domestic bank dependence makes sectors and countries with many SMEs
vulnerable to global banking shocks.