This paper examines policy distortion in capital allocation across firms. Our empirical analysis is based on a loan-level dataset covering the period from August 2006 to July 2010 from one of the largest state-owned banks (SOBs) in China. We exploit the policy announcement of a fiscal stimulus plan in November 2008 as an exogenous shock to the bank‘s loan supply to show that policy intervention results in capital misallocation between SOEs and private firms and between firms in preferential industries and firms in other industries. Interestingly, our sample bank offsets part of this capital misallocation by its tightening credit risk pricing. We further show that the capital misallocation between SOEs and private firms is more severe among new firms without a credit rating available to our sample bank than among existing firms. Finally, our results are robust to the use of an alternative measure of polity intervention based on China‘s monetary policy stance.