Firm Quality Dynamics and the Slippery Slope of Credit Intervention

78 Pages Posted: 1 Dec 2020 Last revised: 8 Jun 2021

See all articles by Wenhao Li

Wenhao Li

University of Southern California - Marshall School of Business

Ye Li

Ohio State University

Date Written: June 7, 2021

Abstract

Central banks and fiscal authorities around the world lent directly to nonfinancial firms on an unprecedented scale during the Covid-19 crisis. Credit support is subject to mispricing due to the potential lack of information on individual borrowers' credit worthiness or the political constraints on discriminatory credit pricing. In a dynamic model, we demonstrate that the mispricing of credit support generates a downward bias in the firm quality distribution that is self-perpetuating. As a result, intervention in the current crisis necessitates future interventions of greater scales, which in turn cause more distortions in firm quality dynamics. Such effects are amplified by firms' forward-looking investment decisions in normal times. Low-quality firms over-invest as they expect underpriced credit support in crises, while, on a relative basis, high-quality firms under-invest. The slippery slope of intervention is a necessary evil, as we show that when carefully designed, credit support still improves welfare.

Keywords: central bank direct lending, lending programs, credit intervention, credit policy, liquidity facilities, heterogeneous firms, firm distribution, unconventional, monetary policy, quantitative easing, corporate cash holdings, financial crises, Covid-19 pandemic

JEL Classification: E5, G0

Suggested Citation

Li, Wenhao and Li, Ye, Firm Quality Dynamics and the Slippery Slope of Credit Intervention (June 7, 2021). USC Marshall School of Business Research Paper, Fisher College of Business Working Paper No. 2020-03-028, Charles A. Dice Working Paper No. 2020-28, Available at SSRN: https://ssrn.com/abstract=3737511 or http://dx.doi.org/10.2139/ssrn.3737511

Wenhao Li

University of Southern California - Marshall School of Business ( email )

701 Exposition Blvd
Los Angeles, CA California 90089
United States

HOME PAGE: http://www.wenhao-li.com

Ye Li (Contact Author)

Ohio State University ( email )

Fisher Hall 836, 2100 Neil Ave
Columbus, OH 43210
United States

HOME PAGE: http://yeli-macrofinance.com

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