<p>Threshold-based supervision converts a continuous measure of asset quality into a discrete regulatory boundary, intended to discipline risk-taking before it threatens solvency. We show that such a threshold can invert its own purpose. We develop the concept of expected regulatory stigma, the anticipated supervisory and market cost a solvent bank expects to bear from crossing a salient non-performing loan (NPL) ceiling, and argue that it induces not an aggregate credit crunch but a reallocation of credit across sectors. Which exposures a bank sheds is governed by net regulatory relief: the gap between a sector’s future NPL contribution and the immediate recognition cost of withdrawing from it. When the riskiest sectors are also the most rollover-fragile, prudence becomes distortionary. Using a hand-collected bank–sector–year panel of Vietnamese banks over 2013–2025, we find that banks in the warning zone just below the 3% ceiling do not reduce aggregate lending but cut credit to commercial and industrial-production borrowers while leaving fragile real-estate and construction exposures intact. The effect is non-linear in proximity, operates through a tilt toward liquid financial assets, and intensifies under macro-financial stress. A ceiling meant to curb risky lending thus crowds out the productive economy while insulating the exposures it was designed to discipline, with direct implications for how supervisors monitor near-threshold banks and unwind regulatory forbearance.</p>