Firm-Bank Linkages and Optimal Policies in a Lockdown

Abstract

We develop a novel framework that features loss amplification through firm-bank linkages. We use it to study optimal intervention in a lockdown that creates cash shortfalls to firms, which must borrow from banks to avoid liquidation. Firms' increase in debt reduces firms' output due to moral hazard. Banks need safe collateral to raise funds. Without intervention, aggregate risk constrains bank lending, increasing its cost and amplifying output losses. Optimal government support must provide sufficient aggregate risk insurance, and can be implemented with transfers to firms and fairly-priced guarantees on banks' debt. Non-priced bank debt guarantees and loan guarantees are suboptimal.

Keywords: COVID-19, Financial Intermediation, firm's leverage, Government interventions, liquidity

JEL Classification: G01, G20, G28