We empirically identify the lending standards applied by banks to small and medium firms over the cycle. We exploit an institutional feature of the Italian credit market that generates a discontinuity in the allocation of comparable firms into different risk categories. We show that in boom banks relax lending standards by narrowing the interest rate spreads between substandard and performing firms. In bust, the tightening of lending standards operates only through a cut in the quantity of lending supplied to substandard firms. These findings suggest that banks rationed credit to substandard firms, which then reported lower production, investment, and employment. 

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