Abstract: This paper studies the impact of the dynamic process of credit reallocation on aggregate innovative activities. To draw out theoretical predictions, we build a model with financial and matching frictions and investigate the consequences of lenders' credit reallocation decisions on borrowers' innovation choices. We show that an intensification of the credit reallocation process improves the matching between lenders and innovative firms but, overall, it disrupts innovation activities. Using a novel data set on bank balance sheets and the number of patents in Italian local markets (provinces) during a period of great economic growth and tighter banking regulation, we construct measures of credit reallocation and examine their effect on innovation. Consistent with the predictions of the model, we find that an increase in credit reallocation depresses innovative activity while aggregate credit growth helps to expand it.