This study investigates the stabilizing role of small and medium-sized local banks and assesses whether high local government debt levels hinder this role. Using bank-level data for all provinces in China, 2015–2021, we find that the lending behavior of small and medium-sized banks is countercyclical when located in provinces with low levels of local government debt but procyclical when located in provinces with high levels of local government debt, particularly during busts. This finding suggests that high levels of local government debt hinder the stabilizing role of small and medium-sized banks, exacerbating regional economic volatility.