Theory offers conflicting predictions on whether and how lenders’ sectoral specialization affects firms’ innovation output. In this paper, we therefore empirically examine the effect of bank specialization on corporate innovation. We find that the sign and the magnitude of this effect varies with the degree of “asset overhang” risk across sectors, which is the risk that a new technology has negative spillovers on the value of a bank’s original loan portfolio. Using patent data to measure firms’ innovation output, our results show that bank specialization improves innovation for firms operating in sectors with low asset overhang risk, but impedes innovation for firms operating in sectors with high asset overhang risk. These results hold for four different measures of asset overhang risk and various robustness checks. We further find that these heterogeneous effects arise through financial contracting. On average, bank specialization eases firms’ financing conditions, but this does not hold for firms operating in innovative sectors with high asset overhang risk. Overall, our findings provide novel insights into the dual facets of bank specialization and, more broadly, the link between banking and innovation.