<p style="text-align: justify;"> <p class="MsoNormal" style="text-align:justify">We show that bank supervision reduces distortions in credit markets and generates positive spillovers for the real economy. Exploiting the quasi-random selection of inspected banks in Italy, we show that financial intermediaries are more likely to reclassify loans as non-performing after an audit. Moreover, they change their lending policies as the composition of new lending shifts toward more productive firms. As a result, productive firms invest more in labour and capital, while underperforming firms are more likely to exit the market. Taken together, our results show that bank supervision is an important complement to regulation in improving credit allocation.<o:p></o:p></p> </p>