Firm Quality Dynamics and the Slippery Slope of Credit Intervention

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